This is because it is not true that they hold a monopoly over the underwriting of shares anymore. Ever since the Glass Steagall Act has been repealed, commercial banks, foreign banks, and a wide variety of institutions have the ability to underwrite shares. Hence, the competition amongst various underwriters should ideally eliminate the underpricing of shares.
The regulations related to securities issues in many countries make the investment bankers liable for any type of misinformation and the financial losses arising from the same.
Hence, if it is proven in court that the investors were sold an overpriced issue, the investment bankers could face a huge liability. Hence, they deliberately lower the valuation and keep a spread for themselves and underprice the shares. However, the fact remains that in order to protect themselves from the lawsuits, the underwriters do have an incentive to provide a lower valuation to the shares. Information Asymmetry: Another reason which has been mentioned by many studies is the fact that huge information asymmetry exists during an IPO.
When an IPO process is announced, the investors are buying into a relatively unknown commodity. The business of the company has been private until then, and hence their financial performance is also not disclosed to the public.
The IPO process does make it mandatory to disclose financials for the past few years. However, there is still a huge information asymmetry. Remarkably, our data show that reduced uncertainty about the aftermarket affects expected excess returns but not IPO underpricing.
Comparing experienced and inexperienced IPO participants, we find that excess returns with respect to fundamentals are significantly reduced, as experienced investors request a smaller absolute uncertainty premium.
However, underpricing relative to the baseline treatment persists. Third, we compare different IPO mechanisms: closed-book auction, open-book auction, and book building.
We find suggestive although inconclusive evidence that in the auctions, underpricing is reduced when compared to our book building treatment which seems to be suggested in the literature Benveniste and Busaba ; Derrien and Womack ; including experimental studies Zhang ; Trauten and Langer ; Bonini and Voloshyna In contrast to the other experimental designs, our experiment involves an aftermarket in which issued shares pay dividends and trade over multiple periods. Our comparison of closed-book and open-book auctions shows that dynamic auctions with price indication may lead to higher revenues for the seller than sealed bid auctions when investors are inexperienced.
Our approach extends the experimental tests on multiple-unit auctions, which usually involve non-tradable assets in a common-value framework Kagel and Levin , to tradable claims of cash flow. In the framework of Smith et al. The paper is structured as follows. Section 2 briefly surveys the literature on IPO underpricing. Section 3 presents the experimental design and our testable hypotheses.
In Sect. Recent reviews have summarized the explanations of the financial economics literature on the IPO underpricing phenomenon Ritter and Welch ; Ritter ; Ljungqvist ; Derrien Demand - side explanations assume different degrees of information among investors.
This asymmetric information leads to oversubscription of attractively priced IPOs as both informed and uninformed investors participate in the offering, whereas unattractively priced IPOs are only subscribed by uninformed investors Rock However, some authors also uncover modes of corruption in relation to the preferential allocation rule Hao ; Liu and Ritter Finally, Kaustia also conjectures the existence of a market-wide psychological bias in IPO underpricing; IPO investors are reluctant to realize losses in the aftermarket, therefore, the likelihood of price appreciation is high.
Our data support this conjecture. In contrast to our comparison of bidding and asking data of IPO investors in the immediate aftermarket, Kaustia compares the market transaction volume for prices above and below the IPO price for the mid-term period, i. IPO market during the period — Supply - side explanations claim that issuers or underwriters willingly underprice IPOs. Welch shows that underpricing mitigates the risk of IPO failure in view of the common uncertainty of an issue.
There are behavioral explanations why the issuer does not get upset with underpricing by the underwriter, including the wealth effect for executives who participate in price increases through stock compensation plans Loughan and Ritter In the signaling theory to IPO underpricing Grinblatt and Hwang , however, the issuing company has an interest in a good return for initial investors to attract more interest in subsequent seasoned offerings.
Footnote 5 A related argument is that the issuer uses the abnormal first-day return as a marketing event to generate greater brand awareness Demers and Lewellen Finally, issuers and underwriters underprice the IPO to decrease the risk of litigation by disappointed shareholders Tinic The reader will notice that all described institutional demand-side and supply-side issues referred to in the literature other than behavioral ones are absent from our controlled laboratory study.
In our study we test underpricing under almost perfect market conditions. In the literature, the extent of underpricing has been related to the IPO mechanism used; auctions have been associated with lower average first-day returns than the book building mechanism Benveniste and Busaba ; Derrien and Womack ; Kutsuna and Smith Theory has shown that under particular assumptions the uniform price auction can be an optimal IPO mechanism Biais et al. Experimental results show that auctions raise higher IPO revenues than fixed price offerings and thus provide some support for this theory, too Bonini and Voloshyna The studies involve common value auctions in the presence Zhang ; Bonini and Voloshyna or absence of Trauten and Langer asymmetric information about the underlying value.
In contrast to these studies, our design involves aftermarket trading, multi-period cash flows, and a control treatment that provides us with a market benchmark to measure IPO underpricing. Nevertheless, auctions have less than one percent of market share Ritter The literature has partly accounted for this observation by the interaction between issuance-size and the contract-choice decision because smaller offers are more likely to use auctions.
Footnote 6 Supply side explanations that predict larger underpricing intended by the issuer argue in favor of the book building approach. According to DeGeorge et al.
In initial public offerings, information on the prospective cash flows and on the intended exchange listing of the securities in the aftermarket is distributed among potential investors. Investors are requested to submit a demand schedule that includes price and quantity, which determine the IPO price.
In our experimental design, the structure of both the IPO mechanism and the aftermarket settings is common information for all participants before the experiment starts, including the number of market participants, financial endowments, and number of issued shares.
Following the IPO, the issued shares are traded in a continuous double auction market similar to the stock exchanges around the world. Footnote 7 Note that across our experimental IPO institutions the expected values and tradability of assets in the aftermarket are constant; only the price mechanism varies systematically. Before we explain the mechanisms of our IPO institutions, we describe the aftermarket along with the fundamental value in detail. In this study, our aftermarket is implemented via the experimental asset market design of Smith et al.
Accordingly, nine subjects trade 18 asset-shares for 15 periods. A share is an entitlement to receive a regular cash dividend that is declared and instantly paid out to the shareholders at the end of each period.
The expected cash dividend per share is thus 24 money units per period. For given zero interest rates, the expected asset-value per share is money units in the first period; it depreciates by 24 money units per period.
After the dividend payment in the last period, shares are worthless. Each of the 15 periods lasts s. Footnote 8 During this time, subjects trade in an electronic continuous double auction market with an open order book. Footnote 9 The bids and asking prices are placed in the order book, which is open and common information to all subjects. An incoming order leads to an immediate transaction if it confirms the best bid or ask on the book, respectively.
The transaction price is thus equal to the best outstanding order on the book. Upon transaction, the matched order is removed from the order book and the transaction price is chronologically recorded in the table of historical prices. The cash and shareholdings of buyers and sellers are updated upon the transaction.
If an incoming order leads to no transaction, however, it is ranked and registered on the order book; better and older orders rank above worse and newer ones. Orders can be removed from the order book without charge by the traders before they lead to a transaction.
At the end of each period, market participants are given information on the cash dividend per share, their resulting personal dividend income, their updated holdings of cash and shares, and a summary of transaction prices open, high, low, and close. All trades in the experiment are equity financed, that is, short sales and margin purchases are not permitted.
The treatment variable is the IPO mechanism. The experiment makes use of between-subjects variation as each subject participates in exactly one treatment, which involves two rounds i. When we compare inexperienced with once-experienced behavior, however, we also make use of within-subject variation.
Footnote 10 The IPO purchase price is determined from the aggregate demand schedule and shares are placed at a uniform price with the high bidders. Up to 18 bids submitted by the subject for single asset-shares compose the individual demand schedule. The bids are positive integers and the schedules are constrained to non-negative cash balances for any clearing price.
If upon bidding, that constraint 1 is violated, the subject is alerted and the demand schedule is not updated until the violation is removed.
The IPO market closes after s. The market demand is computed and the shares are allocated to the bidders of the 18 high bids at a uniform price. Ties are broken randomly. If too few bids are submitted, the IPO fails. Footnote In line with empirical practice, the IPO price equals the highest losing bid. Let B k denote the k th highest bid in the market , then:. Theoretical incentives exist to submit bids in line with and close to the individual preference-revealing amount Vickrey Subjects submit sealed bids, each of which for the purchase of a single asset share.
Their own bids are recorded onscreen in view of constraint 1. No information is given on the bids of other subjects or the likelihood of winning during the auction. After all subjects have submitted their demand schedules, the IPO purchase price is determined given the aggregate demand. The OB treatment involves similar rules to the CB regarding bidding, price determination and the allocation of shares to the winning bidders.
OB is a dynamic auction in which bidders can react to the submitted bids of the others. If individual valuations are independent, such dynamics must not necessarily affect the bidding and the expected IPO purchase price Vickrey Nevertheless, if bids are indications of prices in the asset market, such a revelation of the bids can help to decrease uncertainty about future prices and thus aid price discovery in the IPO. The difference between the IPO price and the aftermarket price might be reduced relative to the other treatments.
One potential adverse effect of the OB is an encouragement of early signaling and late bidding. In a related open auction format but with a multi-unit discriminative auction for certificates of deposits such an effect has not been confirmed Chiang and Kung For multi-unit uniform price auctions we are the first to investigate the late bidding effect see the online appendix.
The book building - BB treatment represents a stylized book building approach involving a two - stage procedure. The first stage involves the closed-book IPO price determination rule equivalently to the CB treatment. Every subject submits a sealed demand-schedule involving up to 18 bids for multiple assets in agreement with Eq. The IPO purchase price is fixed according to Eq. Upon the announcement, investors state the number of shares they are willing to acquire at that fixed price.
Shares are allocated according to a probabilistic pro-rata rule; each share request is equally considered and the winning bids are randomly drawn. The quantity demand of the second stage is individually limited to the number of bids submitted in the first stage. Thus, submission is encouraged of a maximal number of bids in the first stage. As bids in BB have no direct allocation implication, on the other side, incentives exist to low ball on bidding in the first stage to induce a lower offering price as suggested by Ljunqvist For the design of our treatment conditions, we focus on two aspects.
First, the treatment should be close to the existing real-world IPO mechanisms. Second, the treatments should be simple for implementation in the laboratory with minimal differences across treatments. The closed book auction comes very close to the standard IPO auction in the real world.
Indeed, the experiment uses a smaller lot size, a shorter submission period and sets a reserve price of zero. The open book auction is a potentially interesting IPO format, Footnote 13 but direct revelation of price information has been rather exceptional in real world public offerings. Finally, the book building process in our experiment with the purpose to determine a fixed offer price is simplified and transparent compared to the procedure in the real world. The book runner is usually a consortium of investment banks that elicits opinions from institutional investors to determine a range for the IPO price and the size of the capital raise.
Before the first listing on the exchange, this price range is communicated to investors. Hence, our implementation abstracts from many complications in real-world IPOs. The BL is a variant of the design by Smith et al. Subjects are randomly assigned to one of three income classes; the first three subjects are endowed with money units and three shares of assets, the second three subjects are endowed with money units and two shares of assets, and the last three subjects with money units and one shares of assets.
Finally, it should be noted that in the first dividend paying period—the aftermarket in the IPO treatments—the fundamental value equals money units in each of our treatments. This treatment serves as a benchmark, i. To measure underpricing, in line with the literature, we focus on the aftermarket excess return of the IPO. Footnote 14 IPO underpricing in each cohort is then defined by the difference between IPO return and average baseline return:. This definition, which is in line with the IPO literature e.
Footnote 15 In contrast to other experimental studies, our experimental design contains an aftermarket and a control treatment that enable us to measure underpricing in accordance with 2. In contrast to real-world markets, our experimental setting enables us to measure expected excess returns by the price deviations from the fundamental value. The a priori asset value per share in terms of discounted sum of expected dividend payments is money units in each treatment prior to the first dividend payment because the risk-free interest rate is zero in our experiment.
In our experiment, investors have common information about the entire procedure of the IPO and the aftermarket.
They are symmetrically and transparently informed about the dividend distribution and the expected cash flows to equity. The market imperfections emphasized in the above surveyed demand side and supply side explanations of underpricing are absent.
It is a justifiable theoretical benchmark if we propose that the price should equal the discounted sum of expected dividends. Traders face strategic uncertainty about the behavior of the others, about asset pricing and their opportunities to buy and sell in the aftermarket. Therefore, it is reasonable for investors to request an uncertainty premium on IPO investment.
When subjects are inexperienced, the strategic uncertainty about the aftermarket behavior looms larger than when once experienced. Underpricing may be influenced by a psychological bias akin to the disposition effect Shefrin and Statman according to which investors are reluctant to sell below their purchase price. Because in the IPO, every investor pays the same asset price, the IPO price thus could be a psychological anchor of the market.
Allowing for a market-wide impact of the reluctance to sell below the purchase price, there is more upside than downside to share appreciation. Hence, we formulate the first alternative hypothesis. In view of i , one may expect that learning by experience has a decreasing effect on underpricing in a repeated IPO.
Earlier experimental evidence suggests that subjects learn between market repetitions as most illustratively presented by Haruvy et al. We expect also for our IPO treatments that market valuation is closer to fundamentals once subjects are experienced; therefore, we anticipate a repetition effect on expected excess returns of the IPO with respect to fundamentals 2a.
This effect may be reinforced by the decreased uncertainty about aftermarket trading behavior, which again may result in a decreased uncertainty premium required by the market and thus reduced underpricing 2b.
The alternative explanation ii does not preclude but does not require a reduction of underpricing. A market-wide impact of the reluctance to sell below the purchase price implies some degree of persistence of underpricing.
To examine whether IPO investors are reluctant to sell below their purchase price and take a loss we check the asking prices of sellers in the aftermarket. In view of ii we state the following hypothesis. DeGeorge et al. A lack of incentive compatibility Ljunqvist could be the reason for this difference, as low price indications are not necessarily punished. In related literature, Levin and Kagel report evidence that bidding in dynamic multi-unit auctions with feedback is closer to the risk neutral equilibrium than bidding without feedback.
Footnote 16 So, demand reduction may play a bigger role in the closed book format than in the open book format. Generally, the mechanism used can play a role for the pricing of offerings.
Based on the referenced evidence we state the next hypothesis. At the beginning of each treatment, subjects are randomly placed at their computer terminals. Instructions, including a detailed explanation of the dividend stream, are read aloud and questions that arise are answered.
Thereafter, participants practice trading and learn the interface of the aftermarket trading-platform in a trial period without payoff consequences. Next, one dividend stream involving 15 random draws is auctioned off in a pen-and-paper second-price sealed-bid auction to remind subjects of the fundamental asset value process.
Footnote 17 The results of this second-price auction and the realization of the auctioned dividend stream are revealed and privately paid out to the winner only at the end of the experimental session. In the instruction session, we prepare subjects for trading and the pricing of dividend streams.
The first round starts after the remaining instructions were read aloud. After the end of the first round, subjects are asked to repeat the experiment. The second round does not include a repetition of the instructions, and no cash or shares are carried over from the first to the second round. We used an experimental currency unit equivalent to 0.
At the end of the session, the payoff to subjects is the sum of their final cash balances in both rounds adding the show-up fee of four Euros. Subjects were undergraduate students of the universities at Magdeburg and Bonn. Each subject participated in exactly one market involving nine investors. The data consist of seven independent observations in each treatment. The experimental software was programmed using z-Tree Fischbacher Support In Table 1 , the first column records the short-term returns in the BL treatment.
We calculate excess returns using the average price of the first period. Returns are reported for the first and second repetitions of the experiment, when subjects are inexperienced and once-experienced, respectively. We use the one-sample Wilcoxon signed ranks test on the sample of seven independent BL observations to check whether the returns are significantly different from zero.
A third strand of the informational asymmetry theory asserts that underpricing is associated with the weakness of the issuer. The underpricing is intended to compensate the purchasers for this weakness. This theory has found weak evidential support. The investment bank conflict theory, the one Mr. Nocera supports, posits that investment banks arrange for underpricing as a way to benefit themselves and their other clients.
There is some mixed evidence to support this argument. A number of papers have found that investment banks do respond to appropriate incentives to reduce underpricing. Higher I. At least one paper has found that underpricing is reduced by more than 40 percent when an American bank and American investors are involved.
This is attributable to the higher underwriting fees that American investment banks charge. Papers have also found that underwriters who incorrectly underprice their business do lose the chance for future I. The managerial conflict theory posits that management is the primary cause of the underpricing. In its principal form, the manager conflict theory postulates that management creates excessive demand for I. Alternatively, management allows underpricing to ensure that there are many purchasers of the shares.
This means there are no large shareholders created by the I. There is not much evidence to support either form of this theory. Those are the numbers, real and projected, on cash flow. Nevertheless, there are two opposing goals at play. The company's executives and early investors want to price the shares as high as possible in order to raise the most capital and reward themselves most lavishly. The investment bankers who are advising them may hope to keep the price low in order to sell as many shares as possible since higher volume means higher trading fees for them.
The process mixes facts, projections, and comparables:. In theory, any IPO that increases in price on its first day of trading was underpriced, whether it was deliberate or accidental. The shares may have been deliberately underpriced to boost demand. Or, the IPO underwriters may have underestimated investor demand. Overpricing is much worse than underpricing. A stock that closes its first day below its IPO price will be labeled a failure.
An IPO can be underpriced if its sponsors are genuinely uncertain about the reception that the stock will receive. After all, in the worst case, the stock price will immediately climb to the price that investors consider that it's worth. Investors willing to take a risk on a new issue are rewarded. The company's executives are pleased.
That is considerably better than the company's stock price falling on its first day and its IPO being blasted as a failure. Whether it was underpriced or not, once the IPO debuts the company becomes a publicly traded entity owned by its shareholders. Stock Markets. Your Privacy Rights.
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