A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance

68 Pages Posted: 25 Feb 2005

See all articles by Matt Pritsker

Matt Pritsker

Federal Reserve Bank of Boston

Date Written: March 15, 2006


I present a fully-rational symmetric-information model of an IPO, and a dynamic imperfectly competitive model of trading in the IPO aftermarket. The model helps to explain IPO underpricing, underperformance, and why share allocations favor large institutional investors. In the model, underwriters need to sell a fixed number of shares at the IPO or in the aftermarket. To maximize revenue and avoid selling into the aftermarket where they can be exploited by large investors, underwriters distort share allocations towards investors with market power, and set the IPO offer price below the aftermarket trading price. Large investors who receive IPO share allocations sell them slowly afterwards to reduce their trade's price-impact. This curtails the shares that are available to small price-taking investors, causing them to bid up prices and bid down returns. In some simulations, the distorted share allocations and slow unwinding behavior generate post-IPO return underperformance that persists for several years.

Keywords: IPO, Asset Pricing, Market Microstructure, Liquidity

JEL Classification: G12

Suggested Citation

Pritsker, Matthew G., A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance (March 15, 2006). FEDs Series No. 2006-12 , Available at SSRN: https://ssrn.com/abstract=672901 or http://dx.doi.org/10.2139/ssrn.672901

Matthew G. Pritsker (Contact Author)

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States
617-973-3191 (Phone)

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