Market Making Contracts, Firm Value, and the IPO Decision

44 Pages Posted: 17 Aug 2012 Last revised: 18 Feb 2017

See all articles by Hendrik Bessembinder

Hendrik Bessembinder

Arizona State University

Jia Hao

Babson College

Kuncheng (K.C.) Zheng

Northeastern University - D’Amore-McKim School of Business

Date Written: December 14, 2014

Abstract

We examine the effects of secondary market liquidity on firm value and the decision to conduct an Initial Public Offering (IPO). Competitive liquidity provision can lead to market failure as the IPO either does not occur or the IPO price is discounted to reflect that some welfare-enhancing secondary trades do not occur. Market failure arises when uncertainty regarding fundamental value and asymmetric information are large in combination. In these cases, firm value and social welfare are improved by a contract where the firm engages a Designated Market Maker (DMM) to enhance liquidity. Our model implies that such contracts represent a market solution to a market imperfection, particularly for small growth firms. In contrast, proposals to encourage IPOs by use of a larger tick size are likely to be counterproductive.

Keywords: designated market maker, affirmative obligation, information asymmetry, firm value

JEL Classification: D61, D82, G12, G19

Suggested Citation

Bessembinder, Hendrik (Hank) and Hao, Jia and Zheng, Kuncheng (K.C.), Market Making Contracts, Firm Value, and the IPO Decision (December 14, 2014). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2130875 or http://dx.doi.org/10.2139/ssrn.2130875

Hendrik (Hank) Bessembinder (Contact Author)

Arizona State University ( email )

PO Box 873906
Tempe, AZ 85207
United States

Jia Hao

Babson College ( email )

Babson Park, MA 02457-0310
United States

Kuncheng (K.C.) Zheng

Northeastern University - D’Amore-McKim School of Business ( email )

360 Huntington Ave.
Boston, MA 02115
United States

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