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Building the IPO order book: underpricing and participation limits with costly information

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  • Sherman, Ann E.
  • Titman, Sheridan

Abstract

This paper examines the book building mechanism for marketing initial public offerings. We present a model where the underwriter selects a group of investors along with a pricing and allocation mechanism in a way that maximizes the information generated during the process of going public at a minimum cost. Unlike previous models, we take into account the moral hazard problem that is faced by investors when evaluation is costly. Our results suggest that for firms with the most to gain from accurate pricing, the number of investors participating in the offering is larger, and underpricing will be greater. When the demand for accuracy is relatively low, the expected amount of underpricing exactly offsets the investors' costs of acquiring information. However, when the demand for accuracy is high, the expected amount of underpricing can exceed the cost of information and investors can earn rents.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 65 (2002)
Issue (Month): 1 (July)
Pages: 3-29

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Handle: RePEc:eee:jfinec:v:65:y:2002:i:1:p:3-29

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Web page: http://www.elsevier.com/locate/inca/505576

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References

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  1. Habib, Michel A & Ljungqvist, Alexander P, 2001. "Underpricing and Entrepreneurial Wealth Losses in IPOs: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 433-58.
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  3. Hsuan-Chi Chen & Jay R. Ritter, 2000. "The Seven Percent Solution," Journal of Finance, American Finance Association, vol. 55(3), pages 1105-1131, 06.
  4. Randolph P. Beatty & Jay R. Ritter, . "Investment Banking, Reputation and the Underpricing of Initial Public Offerings," Rodney L. White Center for Financial Research Working Papers 2-85, Wharton School Rodney L. White Center for Financial Research.
  5. Laurie Krigman & Wayne H. Shaw & Kent L. Womack, 1999. "The Persistence of IPO Mispricing and the Predictive Power of Flipping," Journal of Finance, American Finance Association, vol. 54(3), pages 1015-1044, 06.
  6. Francesca Cornelli, 2001. "Bookbuilding and Strategic Allocation," Journal of Finance, American Finance Association, vol. 56(6), pages 2337-2369, December.
  7. Titman, Sheridan & Trueman, Brett, 1986. "Information quality and the valuation of new issues," Journal of Accounting and Economics, Elsevier, vol. 8(2), pages 159-172, June.
  8. Hanley, Kathleen Weiss & Wilhelm Jr., William J., 1995. "Evidence on the strategic allocation of initial public offerings," Journal of Financial Economics, Elsevier, vol. 37(2), pages 239-257, February.
  9. William Wilhelm & Alexander Ljungqvist, 2001. "IPO Allocations: Discriminatory or Discretionary?," OFRC Working Papers Series 2001fe08, Oxford Financial Research Centre.
  10. Alexander P. Ljungqvist & Tim Jenkinson & William J. Wilhelm, Jr., 2003. "Global Integration in Primary Equity Markets: The Role of U.S. Banks and U.S. Investors," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 63-99.
  11. Avanidhar Subrahmanyam, 2001. "Feedback from Stock Prices to Cash Flows," Journal of Finance, American Finance Association, vol. 56(6), pages 2389-2413, December.
  12. Cornelli, Francesca & Goldreich, David, 1999. "Bookbuilding and Strategic Allocation," CEPR Discussion Papers 2160, C.E.P.R. Discussion Papers.
  13. Sherman, Ann E, 2000. "IPOs and Long-Term Relationships: An Advantage of Book Building," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 697-714.
  14. Rock, Kevin, 1986. "Why new issues are underpriced," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 187-212.
  15. Tim Jenkinson & William Wilhelm & Alexander Ljungqvist, 2000. "Has the introduction of bookbuilding increased the efficiency of international IPOs?," OFRC Working Papers Series 2000fe04, Oxford Financial Research Centre.
  16. Loughran, Tim & Ritter, Jay R. & Rydqvist, Kristian, 1994. "Initial public offerings: International insights," Pacific-Basin Finance Journal, Elsevier, vol. 2(2-3), pages 165-199, May.
  17. Benveniste, Lawrence M. & Busaba, Walid Y. & Wilhelm, William Jr., 2002. "Information Externalities and the Role of Underwriters in Primary Equity Markets," Journal of Financial Intermediation, Elsevier, vol. 11(1), pages 61-86, January.
  18. Sherman, Ann Guenther, 1992. " The Pricing of Best Efforts New Issues," Journal of Finance, American Finance Association, vol. 47(2), pages 781-90, June.
  19. Avanidhar Subrahmanyam & Sheridan Titman, 1999. "The Going-Public Decision and the Development of Financial Markets," Journal of Finance, American Finance Association, vol. 54(3), pages 1045-1082, 06.
  20. Stoughton, Neal M. & Zechner, Josef, 1998. "IPO-mechanisms, monitoring and ownership structure," Journal of Financial Economics, Elsevier, vol. 49(1), pages 45-77, July.
  21. Hanley, Kathleen Weiss, 1993. "The underpricing of initial public offerings and the partial adjustment phenomenon," Journal of Financial Economics, Elsevier, vol. 34(2), pages 231-250, October.
  22. Benveniste, Lawrence M. & Spindt, Paul A., 1989. "How investment bankers determine the offer price and allocation of new issues," Journal of Financial Economics, Elsevier, vol. 24(2), pages 343-361.
  23. Chowdhry, Bhagwan & Sherman, Ann, 1996. "International differences in oversubscription and underpricing of IPOs," Journal of Corporate Finance, Elsevier, vol. 2(4), pages 359-381, July.
  24. Chowdhry, Bhagwan & Sherman, Ann, 1996. "The winner's curse and international methods of allocating initial public offerings," Pacific-Basin Finance Journal, Elsevier, vol. 4(1), pages 15-30, May.
  25. Mello, Antonio S. & Parsons, John E., 1998. "Going public and the ownership structure of the firm," Journal of Financial Economics, Elsevier, vol. 49(1), pages 79-109, July.
  26. Benveniste, Lawrence M. & Busaba, Walid Y., 1997. "Bookbuilding vs. Fixed Price: An Analysis of Competing Strategies for Marketing IPOs," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(04), pages 383-403, December.
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