THE IPO EFFECT AND MEASUREMENT OF RISK

Numerous empirical studies of the well documented IPO underpricing anomaly have employed a variety of different proxies for risk, none of which seem able to explain a significant portion of initial trading day returns. We find evidence that several of the risk proxies used in these studies are outperformed by the Parkinson Extreme Value method in explaining returns to IPOs; hence, these studies seem to have underestimated the explanatory power of uncertainty to predict IPO returns. Nonetheless, we do find evidence in support of the asymmetric information theories of IPO underpricing. INTRODUCTION AND LITERATURE REVIEW The apparent underpricing of initial public offerings (IPOs) has drawn much attention in the recent financial literature. Empirical studies indicate that abnormally high offer date returns simply cannot be explained by security risk (e.g. McDonald and Fisher [1972] and Ibbotson [1975]). Furthermore, the various models of IPO pricing behavior (discussed below) do not seem to fully explain the behavior of IPO returns. Measuring IPO pricing uncertainty is obviously more problematic than determining the risk of seasoned issues. Lack of price histories and published information both contribute to this difficulty. This paper is concerned with the comparison of the Parkinson Extreme Value method for risk measurement with other commonly used risk surrogates, particularly underwriter reputation and the inverse of gross proceeds. The results of this study indicate that the Parkinson measure does explain a significantly greater portion of IPO underpricing than do the other methods, suggesting that the other studies have underestimated the explanatory power of uncertainty to predict underpricing. Theories of Underpricing One might expect that underwriters and issuers of IPOs along with each of the individual investors would have different sets of information regarding to the value of the issue. Many of the underpricing theories contend that underpricing is a form of compensation for the risk that a particular party bears because of an assumed informational advantage of one of the parties over another, and other theories propose underpricing is compensation for providing information to other participants. Rock (1986) argues that underpricing is a result of the risk assumed by uninformed investors because of the informational advantage of informed investors. Beatty and Ritter (1986) extend Rock’s model and find that underpricing is an increasing function of the ex-ante uncertainty of the issue. Carter and Manaster (1990) develop another extension of Rock’s model demonstrating that as the risk of an issue increases, informed demand will increase, exacerbating the adverse selection problem and the required underpricing. Low risk firms can not creditably distinguish themselves from high risk firms. However, they can employ high reputation investment banks to certify that they are low risk firms, which allows them to underprice by less. Booth and Smith (1986) hypothesize that the underwriter stakes its reputational capital as a bond that securities’ prices reflect all potential negative inside information about the expected performance of the firm. Underpricing provides both protection and compensation for the use of the underwriter’s reputational capital. Tinic (1988) suggests that underpricing is a form of insurance to protect underwriters against potential due diligence legal liabilities. Greenblatt and Hwang (1989) claim that underpricing is a signal by a more informed issuer to indicate firm value and the variance of expected returns to less informed investors. Contrasting the above theories proposing that underpricing is related to private information that the firm has which is not available to investors, Benveniste and Spindt (1990) suggest that informed investors reveal their information to the