Optimal Underwriting Contracts in Securities Issuance Under Rank-Dependent Expected Utility

34 Pages Posted: 19 Jan 2018

See all articles by Mario Ghossoub

Mario Ghossoub

University of Waterloo

Xue Dong He

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management

Date Written: January 12, 2018

Abstract

In public offerings of equity, an investment banking firm (the underwriter) plays an insurance role: through the underwriting contract, the issuing firm transfers the issue risk to the underwriter. Mandelker and Raviv (1977) were the first to examine the risk-sharing characteristics of an optimal contract between the two parties. In this paper, we examine an extension of the classical model of Mandelker and Raviv (1977) to situations where the issuing firm and the underwriter are Rank-Dependent Expected Utility (RDEU) maximizers, with possibly heterogeneous weighting of the distribution of the random net proceeds obtained from the sales of the issues in the market. In an effort to isolate the effect of probability weighting on the shape of optimal underwriting contracts, we consider neither information asymmetry about the realization of the net proceeds, nor unobservability of the underwriter's distributional effort, similarly to Mandelker and Raviv (1977). We give a general closed-form characterization of the optimal underwriting contract in this case, as well as a necessary and sufficient condition for optimality of a firm commitment contract. This condition is naturally related to the relative degree of pessimism between the two parties. As a by-product of our analysis, we provide a crisp characterization of RDEU risk aversion that is of independent interest and that corrects a claim made by Quiggin (1993).

Keywords: IPOs, Best-Efforts Contract, Firm-Commitment Contract, Stand-By Contract, Ambiguity, Knightian Uncertainty, Capacity, Non-Additive Probability, Choquet Integral, Rank-Dependent Expected Utility

JEL Classification: G24, G31, G02, D89

Suggested Citation

Ghossoub, Mario and He, Xue Dong, Optimal Underwriting Contracts in Securities Issuance Under Rank-Dependent Expected Utility (January 12, 2018). Available at SSRN: https://ssrn.com/abstract=3101176 or http://dx.doi.org/10.2139/ssrn.3101176

Mario Ghossoub (Contact Author)

University of Waterloo ( email )

Dept. of Statistics & Actuarial Science
200 University Ave. W.
Waterloo, Ontario N2L 3G1
Canada

HOME PAGE: http://uwaterloo.ca/scholar/mghossou

Xue Dong He

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management ( email )

505 William M.W. Mong Engineering Building
The Chinese University of Hong Kong, Shatin, N.T.
Hong Kong
Hong Kong

HOME PAGE: http://https://sites.google.com/site/xuedonghepage/home

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