Academic journal article Financial Management

The Opening Price Performance of Initial Public Offerings of Common Stock

Academic journal article Financial Management

The Opening Price Performance of Initial Public Offerings of Common Stock

Article excerpt

Abundant empirical evidence indicates that initial public offerings (IPOs) of common stock generate large short-run returns, on average, for investors fortunate enough to purchase the stock at the offer price. Logue |16~, Ibbotson |11~, Ibbotson and Jaffe |12~, Ritter |22~, Miller and Reilly |18~, and Ibbotson, Sindelar, and Ritter |13~ are examples of research that provides empirical evidence of an extraordinary short-run return. While the early studies used monthly data, the latter work narrows the return window to a single day. Ibbotson, Sindelar, and Ritter |13~, for example, find an average return of 16.4% for 4,534 IPOs from 1977-1987, computed from the offer price to the closing price on the first day of trading. We propose to further narrow the return horizon by dividing the first day into an opening price return and an intraday return. The existence of significant first day, secondary market trading volume in our IPO sample (as high as 100% of the offer size) calls into question who gains the benefits of IPO underpricing. Previous empirical work has not addressed this question directly because it uses offer-to-close returns. It is possible that market-making effects may result in a large return during the course of the first trading day, which would imply secondary market traders may participate in the return. The analysis in this paper indicates that the benefits of underpricing accrue almost entirely to the subscribers.

Several theoretical explanations have been suggested for the underpricing of IPOs. Baron |2~ posits that an informational asymmetry between the underwriters and the issuers causes the large first-day return. However, Muscarella and Vetsuypens |19~ find evidence that investment bankers underprice stock in their own firms when going public. Rock |23~ also attributes underpricing to asymmetrically distributed information, but he focuses on the advantage informed investors enjoy over the uninformed. His model is supported by the results of Koh and Walter |15~. Benveniste and Spindt |3~, Chemmanur |5~, and Sherman |24~ suggest that the underpricing is a mechanism to induce investors to produce and reveal private information. Tinic |27~ posits that the underpricing provides an insurance premium against potential legal action by disgruntled investors, and Hughes and Thakor |10~ formalize this notion. Finally, Allen and Faulhaber |1~, Grinblatt and Hwang |6~, and Welch |29~ argue that high-quality issuers purposely underprice initial public offerings to pave the way toward a more successful seasoned offering in the future. This hypothesis is not supported by Jegadeesh, Weinstein, and Welch |14~, however.

Each of the above explanations of underpricing suggests that the market is likely to immediately recognize and correct the situation upon the start of trading in the security. Indeed, in the scenarios suggested by Rock |23~ and Benveniste and Spindt |3~, it is crucial that those investors receiving the initial allocation of the securities reap the benefit associated with the underpricing. In those cases, we expect the large initial return to be realized at the opening of the market because the underpricing represents a payment to those investors participating in the presale market and in the initial allocation.

An alternative explanation leaves open the possibility of a large intraday return. Welch |30~ develops the notion of informational cascades in which individuals ignore their private information and follow the behavior of the preceding individual. In the context of IPOs, Welch's arguments suggest that an issue may be underpriced in order to induce decisions by early investors solicited to purchase a forthcoming IPO. Extending Welch's cascade arguments to the aftermarket suggests that those issues enjoying a larger-than-average initial (offer-to-open) or early return would also enjoy a larger-than-average intraday return as investors attempt to "get on the bandwagon." Consistent with this view, evidence from experimental markets (e. …

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