Ipo Underpricing Theory

2. Theories explaining IPO underpricing Initial public offerings are becoming one of the most investigated topics and interesting to financial economists worldwide. Several prior researches related to IPOs report the tendency to be underpriced. However, it is doubt that why firms sacrifice huge amounts of money on the table for investors' high return and what the price is optimal for IPO shares in the primary market. Many theories have been put forward to explain and test the IPO underpricing against the sample of various countries in different time. According to Ljungqvist (2007), there are four arguments involved in explanation of IPO underpricing: asymmetric information, institutional explanations, ownership and control, and behavioral

This is defined as one of these participants is better informed than the others. Rock (1986) proposes a model which is called a winner's curse by assuming some investors whose information are superior than other investors as well as the issue firms. Generally, informed investors participate the market when attractive shares are offered, while unformed investors buy IPO shares intuitively but they will be unwilling to buy overpriced IPOs or negative return IPOs. In the winner's curse, the informed do not participate the IPO market when unattractive priced IPOs are offered and the uninformed investors will receive all the IPOs they buy for. In the case of oversubscription, the market is crowd out by informed investors, as a result, the return of IPO shares that the uninformed investors receive from allocation is below the average returns. Thus, the uninformed are unwilling to buy IPOs and withdraw from IPO market. Rock (1986) suggests that the IPO market needs the uninformed demand when the informed demand is not enough to response all shares on offer. The positive expected return is an important condition to attract the uninformed investors to participate the IPO market. This leads to the IPO underpricing. (Ljungqvist,

According to Jain and Kini (1999), it is well known that companies with strong performance (i.e. firms with high age and large asset) usually issue large IPO share and hence the issue size can contribute to reduce the uncertainty about IPO performance. This uncertainty is expected to be associated with the underpricing. Consistent with several researches, smaller IPO offering is more risk than a larger size. Therefore, the offering size have the negative relationship with the level underpricing (Ritter, 1987, Clarkson and Merkley, 1994). At the same time, the price of an IPO offering is one of reasonable proxy for uncertainty. Jain and Kini (1999) claim that low priced offers represent high risks, the low offer price may be caused by the low quality of the firms, low demand of investors or both, whereas Daily et al. (2003) argue that the higher offer price is associated with the lower risk and the uncertainty of the company performance. As a result, the firm with higher offer price has the lower underpricing. This is consistent with the evidence that is presented by Chalk and Peavy (1987). They, using 649 IPOs during 1975-82, report that the low priced IPOs indicate the larger level of the underpricing and the underpricing also represents the average risk for the offer