An Alternative Theory of IPO Underpricing

18 Pages Posted: 5 Apr 2015 Last revised: 12 May 2015

Date Written: May 10, 2015

Abstract

This paper offers a new theory of IPO underpricing. The existing theories disregard a basic asymmetry in the IPO contract : the underwriter will lose in case of an unfavorable demand for the new issue but will not benefit from favorable demand for that issue as she (by regulation) has to sell the IPO for the declared IPO price or for less.

I model the underwriters’ and issuers’ profit maximization behavior under this asymmetry and derive their profit/revenue maximization functions. My model yields following results:

· The risk of the contract’s asymmetric design is impossible to diversify , and therefore underpricing is an unavoidable by-product of the IPO process- even when the field of underwriting is fully competitive · IPOs with larger fee will be (on average) less underpriced; · The price adjustment (following road show) will fully reflect “bad news” but will incorporate only a small portion of the “good news” · Side-payments from issuers to underwriters could increase the proceeds of issuers and profits of the underwriters at the same time. We do not observe side-payments, but we do observe allocation of warrants to underwriters (which give the underwriters a stake in the share’s upside) and increases the IPO prices. · Underwriters are always interested in higher fees; the issuers’ IPO proceeds may be increase by a modest increase in the underwriter’s fee k, i.e., higher underwriter fees may serve the interest of both parties · Underwriters’ fees are a decreasing function of the issue size · Fluctuations in average level of underpricing due to fluctuations in market

Keywords: IPO underpricing

Suggested Citation

Cherkes, Martin, An Alternative Theory of IPO Underpricing (May 10, 2015). Available at SSRN: https://ssrn.com/abstract=2590101 or http://dx.doi.org/10.2139/ssrn.2590101

Martin Cherkes (Contact Author)

NYU ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

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