The extraordinary expected return from the first twenty-four hours of the initial public offering ( IPO ) trading brings the great attending of the issue of the IPO underpricing. The object of this paper is to bring forth a through and in-depth literature reappraisal in the field of the underlying logical thinking of the underpricing. The relationship between the underpricing and the asymmetric information has been the major subject being studied. Three footing theories are focused: 1 ) the Rock ‘s ‘the victor ‘s expletive ‘ sing to the inauspicious choice theoretical account ; 2 ) the antique ante uncertainness and the asymmetric information ; 3 ) the signalling theory with the moral jeopardy theoretical account. The huge empirical grounds is provided on the footing of the positive relationship between the underpricing and the asymmetric information. The concluding decision indicates a farther research way.
This paper aims to supply a reappraisal of the modern-day literature in relation to the phenomenon of the underpricing of the IPOs. The implicit in theories of the asymmetric information are the major subject to be investigated due to the word bound.
The theoretical principle has provided a great implicit in concluding on the underpricing of the initial public offering. The inauspicious choice, ex ante uncertainness and the signalling theory based on the moral jeopardy are the major concerns in this literature reappraisal. The nonvoluntary underpricing and the voluntary underpricing have brought the visible radiation into the analyses. The critical treatments of these underlying theories of the underlying of the IPOs have besides been exploited.
The empirical findings across different states are brought into the paper with varies informations and methods. The empirical findings which supports or do non back up the theories are exploited. The concluding behind the incompatibility of the findings is discussed. However the informations used in the empirical surveies are old and the modern-day informations may necessitate to be exploited in the hereafter surveies. The future tendency for the surveies on the issue may take to the more defined geographical government which may give a better support of the implicit in theoretical principle.
The underpricing of an initial public offering ( IPO ) has become a cosmopolitan phenomenon. This underpricing occurs when the monetary value leaps on the first twenty-four hours of the trading. Bodie et Al. ( 2009 ) has given a dramatic illustration of this phenomenon. VA Linux ‘s portion was sold in an IPO at $ 30 per portion ; nevertheless it turned to $ 239.25, which gives a 698 % return in that twenty-four hours ( Bodie et al. 2009, p.56 ) .
Economists have been seeking to explicate this so called “ IPO underpricing mystifier ” ( Lorenzo and Fabrizio ( 2001 ) . Several literature theories are developed. The underpricing is associated with the booking-keeping strategy. At the book-keeping phase, the investing bankers will inquire the big institutional and other investors to portion their ratings about the house, and so the investment bankers will set their initial value of the offering monetary value and the Numberss of the portions which are traveling to be offered. ( Bodie et al. 2009 )
Benveniste and Spindt ( 1989 ) argued that the underpricing is used to honor institutional investors for uncovering more accurate information at book-keeping. Hughes and Thakor ( 1992 ) thought that the underpricing is used to take the possible legal amendss in order to bring on the issuers to take part.
Asymmetrical information is one of the major theories for the logical thinking of the underpricing which includes the inauspicious choice, the signaling theory and the bureau theoretical account. This paper focuses on the first two theories by analyzing the inauspicious choice and the signaling theories. The theory of the ex-ante uncertainness has besides been studied. The theories above are based on the opposite relationship between the pricing and the first twenty-four hours addition. The back uping empirical surveies have been provided every bit good as the inconsistent findings. However those findings are wide in an international context without necessary surveies within a defined geographical government. The regional defined surveies may give more consistent consequences harmonizing to the theories.
Adverse Selection Models
The Rock ‘s theoretical account and Empirical Evidence
The issue of the inauspicious choice can be the starting point while sing the IPO underpricing. Rock ( 1986 ) formed a theoretical account called ‘the victor ‘s expletive ‘ . He separated investors in two types: absolutely informed with superior information and uninformed with less information and besides the issue houses and their investment bankers as uninformed about the value of the house. Under Rock ‘s theoretical account, the underpricing is needfully used to counterbalance uninformed investors to guarantee that they will take part in the IPO market. As the informed investors can obtained all the portions on demand, nevertheless the uninformed investors can non take such an advantage. Therefore uninformed investors who are disadvantaged from holding less information are likely to go out from the IPO market. In order to carry through the offering of the portions in the IPO market, there is a demand to maintain the uninformed investors in. Rock ‘s theoretical account is conceptually different from the initial inauspicious choice theoretical account in Akerlof ‘s ( 1970 ) ‘s paper ( Jenkinson and Ljungqvist 2001, p.64 ) , where Akerlof ( 1970 ) suggested that the uninformed purchasers exit from the used auto market if the uninformed investors are disadvantaged from the quality distribution of the used auto.
The inquiry arises on how to through empirical observation prove the Rock ‘s inauspicious choice theoretical account. Jenkinson and Ljungqvist ( 2001 ) have shown the manner that after seting the rationing decently, uninformed investors ‘ unnatural returns should be zero on norm and besides said this is potentially testable. The Rock ‘s theoretical account has been given positive supports in Singapore, UK and Finland from Koh and Walter ( 1989 ) , Levis ( 1990 ) and Keloharju ( 1993b ) ‘s empirical trials, which found that the underpricing returns travel towards riskless rate while seting the rationing decently. However it was besides found the dissension in Hongkong from McGuiness ( 1993a ) . These documents have shown that the grounds largely supports the Rock ‘s theoretical account from the states used fixed-price instead than the book-building ( Jenkinson and Ljungqvist 2001, p.65 ) . However the book- edifice mechanism has been widely used presents, for illustration, Japan disused the auction mechanism and started to utilize the book-building mechanism in 1997 ( Jenkinson and Ljungqvist 2001, p.40 ) . The agnosticism may originate whether the Rock ‘s inauspicious choice theoretical account still holds presents harmonizing to the widely used book-building mechanism. The farther research on this issue should be more addressed through empirical trial in more states where book-building strategies are used.
Criticisms of Rock ‘s theoretical account
Jenkinson and Ljungqvist ( 2001 ) brought three points of the unfavorable judgments about the Rock ‘s theoretical account. First, they has criticized that the Rock ‘s theoretical account is ‘a deceivingly simple and instead intuitive observation ‘ while doing ‘a jeer of simple steps of dumping which are based on an every bit leaden norm. ‘ ( Jenkinson and Ljungqvist 2001, p.73 ) ) Second, as Rock assumed that the issuers must pay to counterbalance the uninformed investors to take part in the initial offering market, there is a contrary position originating. That is while the Numberss of informed investors in the market are limited ; the uninformed investors could merely put through the informed investors by paying a committee. Therefore there is no demand to worry about the inadequacy of the Numberss of investors who can take up the portions on offering if the uninformed investors withdraw from the market. ( Jenkinson and Ljungqvist 2001, p.73 ) Third, the inquiry is how the allotment prejudice truly is in world. Jenkinson and Ljungqvist have argued this reply relies on the differentiation between uninformed and informed investors. They have found that informed and uninformed investors are hard to be distinguished at empirical trial. Past surveies have distinguished them through the institutional and retail investors. ( Jenkinson and Ljungqvist 2001, p.73 ) Further, Hanley and Wilhelm ( 1995 ) showed that the institutional investors do profit from the underpricing, nevertheless no difference was found at the allotment size that institutional investors by and large obtain. Jenkinson and Ljungqvist ( 2001 ) besides argued that the uncertainty should be casted harmonizing to the Rock ‘s theory as many theoreticians have found there are unseen information being distributed within investors, the differentiation between uninformed and informed may be absurd. Last, as Rock assumed the involvements of the issue house and the investing bankers are in line, an bureau issue can happen as they do hold a struggle of the involvement in world ( Jenkinson and Ljungqvist 2001 ) .
Decrease of the inauspicious choice cost
As the underpricing brings an nonvoluntary cost to the issuer, how to extenuate the hazard of inauspicious choice is another of import issue to be addressed. ( Jenkinson and Ljungqvist 2001, p.68 ) Florin and Simsek ( 2007 ) foremost distinguished the definition of the inauspicious choice from the moral jeopardy. The inauspicious choice was found when there is ‘hidden information ‘ in comparing with the moral jeopardy where there is a ‘hidden action ‘ . In an illustration of a engineering house, the investors do non hold accurate information in general about the house, for illustration, its R & A ; D capablenesss. Directors may conceal the house ‘s unpleasant internal information from the foreigners in order to invalidate them non to buy the initial portions. In order to extenuate the hazard of inauspicious choice, investors likely look at the market indexs that is associated with high executing IPOs. Florin and Simsek ( 2007 ) have found that the heat of the industry sector ‘s IPO market and the size of the offering are two indexs, which positively link with the IPO public presentation on the first twenty-four hours, where they used a sample of 270 houses from public offerings in 1996. ( Florin and Simsek 2007, pp.132-140 )
Last, Rock ‘s theory falls into the nonvoluntary theory of the underpricing. That is to state that the underpricing in the IPOs is an nonvoluntary action to response to some necessary job. Jenkinson and Ljungqvist ( 2001 ) have argued that when taking into the rating of the initial monetary value, it is necessary to take into history the private information disseminated among all the investors. Therefore, the stamps and the auctions may be a great solution. However the stamp offer was unpopular in world except in France. ( Jenkinson and Ljungqvist 2001, p.74 )
The Ex ante Uncertainty and Asymmetric Information
The Theoretical Rationale and Empirical Evidence
An ‘ex ante uncertainness ‘ is an uncertainness about the value per portion where an investor can non be certain about an offering ‘s value one time the public trading starts. This is studied in a great item in Beatty and Ritter ( 1986 ) ‘s paper. Betty and Ritter have demonstrated that the greater the ex ante uncertainness is, the greater the figure of investors who turns into the informed investors is. This is why there is a positive relationship between the ex ante uncertainness and the grade of the underpricing. Beatty and Ritter has besides found that “ due to the Rock ‘s victor ‘s expletive job facing uninformed investors, all of the net incomes accruing to investors due to dumping will be received by informed investors. Investors seeking these net incomes, nevertheless, will incur sufficient costs so that the sum costs of going informed equal the sum of money ‘left on the tabular array ‘ ” ( Betty and Ritter 1986, p.229 ) . At the empirical testing phase, Betty and Ritter used the age of the company, the gross revenues gross in the last twelvemonth before the IPO issue and the volume of the offering as the placeholders for the ex ante uncertainness ( Betty and Ritter 1986 ) .
Corwin ( 2003 ) has besides found seasoned equity offers with higher degrees of uncertainness and asymmetric information is more underpriced. Their empirical consequences have besides suggested that the monetary value uncertainness has an of import consequence in the seasoned equity offers but the function of the asymmetric information consequence is weak. ( Corwin 2003, p.2276 )
Decrease of the ex ante Uncertainty
Betty and Ritter ( 1986 ) further argued that the ensuing underpricing equilibrium is enforced by investing bankers. They found that ‘an investing banker who ‘cheats ‘ on, this underpricing equilibrium will lose either possible investors if it does n’t underpriced plenty or issuers if it underpriced excessively much, and therefore give up the value of its repute capital. ‘ ( Betty and Ritter 1986, p.213 ) This implies that one manner to cut down the asymmetric information is to engage a high reputable investment banker. As the investment bankers often engage in the IPO market, they have strong inducement to keep their reputes for their work, so arguably they probably convey the accurate information to the market in comparing with the less reputable investment bankers ( Beatty and Ritter 1986 ; Carter and Manaster 1990 ; Yung and Zender 2008 ; Jenkinson and Ljungqvist 2001 ) .
The Signalling Theory and the Moral Hazard
The Theoretical Rationale
The behavioral finance literature assumes that the investors are non to the full irrational therefore they are likely to respond to rumor about the IPOs and besides considers IPOs as short-run gambles ( Shleifer 2000 ) . Therefore, some theoreticians argued that certain public signals may take investors to outguess the pricing procedure, and to do determination based on what they think what other investors would make other than the judgement on the true value of the houses ( Ritter and Welch 2002 ; Welch 1992 ) .
The inquiry leads to what can be considered as a public signal. Allen and Faulhaber ( 1989 ) , Grinblatt and Hwang ( 1989 ) and Welch ( 1989 ) have modelled the IPO underpricing as a manner to signal house ‘s quality. They assumed that the companies know that their true values better than the investors and there are two-stage merchandising stairss at the IPOs. The high quality house can retrieve the cost of the underpricing through the subsequent arrangement at more favorable monetary values ; hence there is a great chance that the high quality house will be estimated as a possible good investing by the investors. The underpricing is a mean to convert the possible investors that the house has a great value. ( Allen and Faulhaber 1989 ; Grinblatt and Hwang 1989 ; Welch 1989 )
This is similar from the instance of moral jeopardy in Akerlof ( 1970 ) ‘s paper ( Jenkinson and Ljungqvist 2001 ) . Akerlof ( 1970 ) claimed that Sellerss will necessitate to dump the high quality auto at the earlier phase before they can set up a good repute for selling a good quality auto. This is stating that the Sellerss are taking actions to signal that they have a good quality auto ( Akerlof 1970 ) .
There are more quality signals which have been considered. For illustration, the quality of the venture capital house ( Dolvin 2005 ) , the per centum of the ownership of the top direction squad ( Florin et al. 2003 ) , and the repute of the investing banker ( Carter et al. 1998, Florin and Simsek 2007 ) .
Empirical Evidence of the Signalling theory
Allen and Faulhaber ( 1989 ) and Welch ( 1989 ) ‘s theoretical accounts have argued the underpricing is used to help the returning to the after IPO market. Their empirical trials have been done and besides relevant merely harmonizing to the arrangement occur in the twelvemonth instantly after the initial public offering ( Lorenzo and Fabrizio 2001, p.5 ) .Therefore the agnosticism exists simply to make with the empirical inquiry on the whether the houses do hold the two phase merchandising schemes ( Jenkinson and Ljungqvist 2001 ) . There are two specific issues considered in proving the signalling theory: 1 ) the subsequent equity offering and 2 ) the insider merchandising at the aftermarket.
Subsequent Equity Offer
Earlier surveies showed that a positive relationship exists between the underpricing and the chance and size of subsequent equity offering in Jegadeesh et Al. ( 1993 ) . Jegadeesh et Al. ( 1993 ) showed that the market feedback hypothesis is consistent with the signaling theory. However, Jegadeesh et Al. ( 1993 ) argued that the market feedback hypothesis in the early post-IPO clip has the equal or greater explanatory power for the chance of reprint sing to the underpricing. The market feedback hypothesis states that the issuers have undervalued the fringy return as the market is better informed than the house itself. Therefore the issuers do non necessitate to trust on the dearly-won underpricing to signal to the market about the quality of the house and the grounds in back uping the signaling theory as the chief determiner for the underpricing is weak. ( Jegadeesh et al. 1993 )
Garfinkel ( 1993 ) argued that Jegadeesh et Al. ‘s work has ignored the control of the consequence of the partial accommodation procedure on dumping The partial accommodation procedure is a procedure where the investing bankers partly adjust the portion monetary value and figure of portion issued harmonizing to the demand at the pre-selling period of IPO ( Garfinkel 1993 ) . Garfinkel ( 1993 ) has found that the signaling consequence has small impact on the chance of the reprint of the seasoned offering after commanding the ex-ante uncertainness, the house ‘s post-stock monetary value public presentation and the partial accommodation procedure.
Filatotchev and Bishop ( 2002 ) says that the ‘underpricing represents a direct wealth transportation from the laminitiss and initial stockholders to new investors, but its extent can be reduced by a figure of governance-related ‘signals ‘ that may potentially heighten steadfast value, such as maintained portion ownership by IPO insider ‘ . ( Filatotchev and Bishop 2002, p.941 )
The trial for the signaling theory is done in Garfinkel ( 1993 ) ‘s paper by analyzing the relationship between the underpricing and the subsequent insider gross revenues. Garfinkel ( 1993 ) argued if the underpricing works as signal, the insiders of the houses with more underpricing should sell portions more frequently than those insiders in the houses with less underpricing. Insiders can retrieve the cost of the underpricing through the subsequent gross revenues at a higher monetary value. However the empirical consequences do non back up the theory ( Garfinkel 1993 ) .
The ‘lock-in ‘ period is the clip which restrains the pre-IPO stockholders from trading in the after-market. Jenkinson and Ljungqvist ( 2001 ) has argued that the longer the ‘lock-in ‘ period is, the exogenic events will impact the good effects of the underpricing. The ‘lock-in period ‘ in the USA is by and large 180 yearss ; nevertheless it can be 2 old ages length ( Jenkinson and Ljungqvist 2001, p.79 ) . Garfinkel ( 1993 ) ‘s information follows the two -year -interval of the trading in CRSP day-to-day NASDAQ and NYSE/AMEX after the issue. One may reason that the inconsistent consequence from Garfinkel ( 1993 ) may be caused by the ‘lock-in ‘ period, even though he contended that it should non be affected by the ‘lock-in ‘ period as the period is by and large less than 2 old ages.
The survey of the underpricing has been tremendous involvements among the past theoreticians in both theoretical and empirical manner. The field in relation to the relationship between the asymmetric information and the underpricing has been studied in legion theoretical accounts and foundations.
This paper focuses on three theoretical accounts: the inauspicious choice theoretical account, the ex ante uncertainness and the moral jeopardy in the signalling theoretical account. The behavior finance in relation to the investor s behavior and the bureau theoretical account in relation to the underlying logical thinking of the IPO underpricing have non been studied here due to the clip efficiency. First, Rock ( 1986 ) initiated the so called ‘the victor ‘s expletive ‘ theoretical account in relation to the inauspicious choice theory in order to explicate the underlying logical thinking of the underpricing. This has been considered as the nonvoluntary action necessary to work out the job of likeliness of the uninformed investors who will go forth the market. Several unfavorable judgments of the Rock ‘s theoretical account have been developed and besides been explained in deepness. Second, the relationship between the ex ante uncertainness and the underpricing is considered. Third, the signalling theory based on the moral jeopardy is explained in item. This is a calculated action considered by the issuer to signal the houses ‘ quality. The empirical trial sing to the specific issue as the subsequent equity offering and the insider trading has non supported the signalling theory.
Overall the inclination to cut down the asymmetric information has been found. First, the heat of the industry sector ‘s IPO market and the size of the offering are the two indexs for investors to look into for the decrease of the inauspicious choice cost. Second, Jenkinson and Ljungqvist ( 2001 ) have considered the auction and stamps alternatively of the fixing monetary value may be a solution. Third, engaging a reputable investment banker can cut down the asymmetric information. Finally, the empirical grounds provided in this paper is in the wide international context. The more defined geographical surveies and analysis of the underpricing and the asymmetric information should be considered in the hereafter as the Torahs of the IPOs are wholly different in different states. The geographical defined surveies may give us more accurate and consistent consequences sing to the theories.