Signalling and the Pricing of New Issues

Posted: 17 Nov 2009

See all articles by Mark Grinblatt

Mark Grinblatt

University of California, Los Angeles (UCLA) - Finance Area; Yale University - International Center for Finance; National Bureau of Economic Research (NBER)

Chuan-Yang Hwang

Nanyang Technological University (NTU)

Date Written: 1989

Abstract

A puzzling phenomenon in finance is the underpricing of new issues of common stock. A signaling model, with two signals, two attributes, and a continuum of signal levels and attribute types, is developed to explain this underpricing. The model has two signals: (1) the fraction of the new issue retained by the issuer, and (2) its offering price. These convey to the investors the unobservable intrinsic value of the firm and the variance of its cash flows. In the model, an issuer has better information about future cash flows than outside investors; to overcome the asymmetric information problem, the issuer signals the firm's value by offering discounted shares and retaining some of the new shares. The model is consistent with the rationale for underpricing given by many investment professionals. The model's signaling schedule (a function of project variance and issuer's fractional holdings) reveals that the intrinsic value of the firm is positively related to the underpricing of the new issue; there is a positive relation between project variance and underpricing discount; there is a negative relation between the fractional holdings and the project variance; that fractional holdings and underpricing discount are positively related; that fractional holdings and firm value are positively related; and that firm's value and variance are positively related. Three empirical predictions and eight testable implications are articulated. Existing empirical evidence on new issues is consistent with the model's implications. Two applications are suggested: where high firm value is signaled through (1) expensive investment bankers, auditors, and advertising, and (2) high dividends. (TNM)

Keywords: Signaling, Startups, Initial public offerings (IPO), Stock offerings, Underpricing, Valuation, Market value, Prices, Shareholders, Information asymmetry

Suggested Citation

Grinblatt, Mark and Hwang, Chuan-Yang, Signalling and the Pricing of New Issues (1989). The Journal of Finance, Vol. 44, Issue 2, p. 393-420 1989. Available at SSRN: https://ssrn.com/abstract=1505215

Mark Grinblatt (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1098 (Phone)
310-206-5455 (Fax)

Yale University - International Center for Finance

Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Chuan-Yang Hwang

Nanyang Technological University (NTU) ( email )

Singapore, 639798
Singapore
65-67905003 (Phone)
65-6791-3697 (Fax)

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