Sentiment Traders & IPO Initial Returns

Abstract

The distinct regulatory design of Indian IPOs permits an empirical evaluation of IPO underpricing models against those that model IPO initial returns as a consequence of overpricing. Characteristics of the Indian bookbuilding process allow us to study the timing and subscription patterns of different investor groups and to dissect IPO returns into two distinct components: one relating to pre-listing pricing by the underwriter and the other to the initial return from first day’s trade in the post-listing period. We find that a transparent bookbuilding process can alleviate the winner’s curse problem for retail investors but that does not eliminate IPO initial returns. Further, IPO initial returns persist but do not increase even if investment bankers are stripped of their discretionary allocation power. These results are not supportive of voluntary underpricing models. We find that the unmet demand of non-institutional investor groups is the primary driver of the IPO initial return. We consider these results to be supportive of the Derrien (2005) and Ljungqvist, Nanda and Singh (2006) models and consistent with the conclusions in Loffler, Panther and Theissen (2005) and Ljungqvist, Cornelli and Goldreich (2006).

Keywords: IPOs, bookbuilding, underpricing, winner’s curse, sentiment traders

JEL Classification: G11, G15, G18