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A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance

  • Matt Pritsker
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    I present a fully-rational symmetric-information model of an IPO, as well as a dynamic imperfectly competitive model of the aftermarket trading that follows. The model helps explain why IPO share allocations favor large institutional investors. It also helps to explain IPO underpricing, and underperformance, and the large fees charged by underwriters. The critical assumption in the model is that underwriters need to sell a fixed number of shares at the IPO or soon thereafter in the aftermarket, but they want to avoid selling in the aftermarket because there are some aftermarket investors who have market power and can affect the prices received by the underwriter. To maximize revenue and avoid unnecessary aftermarket sales, the underwriter distorts share allocations toward those those investors who have market power, and he sets the offer price at the IPO below the aftermarket price that will prevail shortly after the IPO. In the aftermarket model, I show that there are share allocations that can generate arbitrarily high levels of return underperformance for very long periods of time. In some simulations, the distorted share allocations at the IPO generate return underperformance that persists for more than one year. The underwriter can dilute investor's market power by participating for longer periods of time in the aftermarket. By doing so, he sometimes substantially increase the revenue that is raised by the IPO issuer

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    File URL: http://repec.org/sce2005/up.12414.1107229829.pdf
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    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 414.

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    Date of creation: 11 Nov 2005
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    Handle: RePEc:sce:scecf5:414
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    1. Ljungqvist, Alexander P. & Nanda, Vikram & Singh, Rajdeep, 2001. "Hot Markets, Investor Sentiment and IPO Pricing," CEPR Discussion Papers 3053, C.E.P.R. Discussion Papers.
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    3. Wilson, Robert, 1979. "Auctions of Shares," The Quarterly Journal of Economics, MIT Press, vol. 93(4), pages 675-89, November.
    4. Katrina Ellis & Roni Michaely & Maureen O'Hara, 2000. "When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket," Journal of Finance, American Finance Association, vol. 55(3), pages 1039-1074, 06.
    5. Andrew Ellul & Marco Pagano, 2006. "IPO Underpricing and After-Market Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 381-421.
    6. Rock, Kevin, 1986. "Why new issues are underpriced," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 187-212.
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    9. Jay Ritter & Ivo Welch, 2002. "A Review of IPO Activity, Pricing and Allocations," Yale School of Management Working Papers ysm258, Yale School of Management, revised 01 Apr 2002.
    10. Biais, Bruno & Bossaerts, Peter & Rochet, Jean-Charles, 1996. "An optimal IPO mechanism," IDEI Working Papers 59, Institut d'Économie Industrielle (IDEI), Toulouse.
    11. Shane A. Corwin & Jeffrey H. Harris & Marc L. Lipson, 2004. "The Development of Secondary Market Liquidity for NYSE-Listed IPOs," Journal of Finance, American Finance Association, vol. 59(5), pages 2339-2374, October.
    12. FranÁois Derrien & Kent L. Womack, 2003. "Auctions vs. Bookbuilding and the Control of Underpricing in Hot IPO Markets," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 31-61.
    13. Katrina Ellis & Roni Michaely & Maureen O'Hara, 2002. "The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks," Journal of Finance, American Finance Association, vol. 57(5), pages 2289-2316, October.
    14. 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.
    15. Jenkinson, Tim & Jones, Howard, 2002. "Bids and Allocations in European IPO Bookbuilding," CEPR Discussion Papers 3644, C.E.P.R. Discussion Papers.
    16. Stapleton, R C & Subrahmanyam, Marti G, 1978. "A Multiperiod Equilibrium Asset Pricing Model," Econometrica, Econometric Society, vol. 46(5), pages 1077-96, September.
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