argue that issuers are less concerned about underpricing when offer prices are revised upwards, since their personal wealth has also increased, due to a higher value of their retained shares. Therefore, they reduce their monitoring behavior, thus allowing underwriters to underprice more. Loughran and Ritter (2002) state that underwriters might leave substantial amounts of money on the table to benefit some investors. Investors who receive allocations of underpriced shares reward investment banks with business such as trading commissions, SEOs and subsequent IPOs. In Baron’s model (Baron, 1982), issuers face a tradeoff between underpricing and monitoring the underwriter. Underwriters use promotional efforts to create demand for the IPO, but these efforts are costly for a bank. In order to make sure that the investment bank puts in the right amount of effort in marketing the shares, the issuer monitors the underwriter. Because this monitoring is costly, the issuer may allow some underpricing. Other explanations of IPO underpricing include the lawsuit avoidance hypothesis and the incentive investment bankers get from post IPO trading profits.Table 1 gives an overview of the literature review. Habib & Ljungqvist, 2001 Hanley & Wilhelm, 1995 Carter & Manaster, 1990 Beatty & Ritter, 1986 Rock, 1986 Author Information asymmetry: Investors are less informed Table 1: IPO underpricing theories Winner’s Curse/Realignment of incentives Winner’s Curse, uninformed investors need to be compensated with underpricing Winner’s Curse, uninformed investors need to be compensated with underpricing Winner’s Curse, uninformed investors need to be compensated with underpricing Winner’s Curse: Uninformed investors need to be compensated with underpricing Theory Firms promote the issue to reduce the need for underpricing Institutional (informed) investors receive more allocations in underpriced shares Firms signal firm quality by selecting prestigious underwriters Underwriters that underprice too much or too little lose market share Underpricing is positively related to risk Relation
Underpricing is negatively related to promotion costs. Promotion costs are positively related to the size of the IPO. Underpricing is negatively related to insider selling Positive relation between underpricing and institutional allocations Underwriter reputation is negatively related to underpricing Residual underpricing (Both positive and negative) is negatively related to underwriter market share Underpricing is positively related to risk. Risk proxies are, firm size, firm age, IPO size, etc. Testable implications Habib & Ljungqvist, 2001 Hanley & Wilhelm, 1995; Aggarwal, 2002; Koh & Walter, 1989; Amihud et al., 2003; Chowdry & Sherman, 1996 Loughran and Ritter, 2004 (in 1980’s); Michealy & Shaw, 1994 Beatty Ritter, 1986; Dunbar, 2000 Beatty Ritter, 1986; Michealy & Shaw, 1994; Loughran & Ritter, 2004 Supporting evidence Lee et al. 1999, data on allocations is hard to come by. No evidence that informed investors request more underpriced shares Loughran and Ritter, 2004: in the 1990’s and bubble period, the sign flipped; Ljunqvist & Wilhelm, 2003: Underwriter choice is endogenous Ruud 1993, underpricing is to severe to be compensation for underpricing; Derrien 2005, short selling constraints prohibit price correction. Criticism Loughran & Ritter, 2002 Benveniste & Spindt, 1989 Author Information asymmetry: Investors have superior information to issuers and underwriters Welch, 1989 Bikhchandani et al., 1992; Ritter, 1998 Author Table 1 Continued Prospect Theory Book Building, underwriters use Book Building to solicit information from investors, investors who provide information are rewarded with underpricing and allocations Theory Signalling hypothesis: firms deliberately underprice to signal good firm quality Bandwagon hypothesis Theory Issuers are less concerned about underpricing when prices are revised upwards Underwriters do not fully adjust prices upwards when favorable information comes to light. Informed investors receive more allocations. Prestigious underwriters are better at extracting information Relation Firms that are underpriced more, are more likely to issue subsequent SEOs IPOs are either extremely oversubscribed or undersubscribed Relation
Price revisions are positively related to underpricing Price revisions are positively related to underpricing, institutional investors recieve more allocations, underwriter reputation is negatively related to underpricing Testable implications Underpricing is positively related to the probability of an SEO Not empirically tested Testable implications Loughran & Ritter, 2004; Hanley, 1993 Hanley, 1993; Ritter & Welch, 2002; Cornelli & Goldreich, 2001; Loughran and Ritter, 2004 (in 1980’s); Michealy & Shaw, 1994; Benveniste et al. 2002, 2003 Supporting evidence Jegadeesh et al., 1993 Amihud et al., 2003 Supporting evidence Loughran & Ritter, 2002: Prices are not revised upwards when positive public information comes to light (stock market rallies) Criticism Michaely & Shaw, 1994 Criticism Loughran & Ritter, 2004 Loughran & Ritter, 2004 Ljungqvist & Wilhelm, 2003 Baron, 1982 Author Information asymmetry: underwriters have superior information to issuers Table 1 Continued Analyst lust hypothesis Spinning hypothesis Realignment of incentives Underwriters have an incentive to underprice Theory Prestigious underwriters have star analysts, therefore issuers allow more underpricing Issuing decision makers invest in other underpriced IPOs to make a quick profit During the 90s insider stakes dropped, furthermore directed share programs emerged, reducing the cost of underpricing to decision makers Underpricing is a substitute for promotion activities Relation