Academic journal article Financial Management

Underpricing and Ex Post Value Uncertainty

Academic journal article Financial Management

Underpricing and Ex Post Value Uncertainty

Article excerpt

As documented by a vast empirical literature, initial public offerings (IPOs) are characterized by underpricing. A number of papers have shown that underpricing is directly related to the amount of ex ante uncertainty concerning the IPOs valuation. Recent theoretical papers propose that not all value uncertainty is resolved prior to the start of trading, but rather continues to be resolved in the beginning of the after market. We term this type of uncertainly as ex post value uncertainty and develop proxies for it. We find strong support for the existence of ex post value uncertainty and find that including a proxy for it more than doubles the explanatory power of previous models.


As documented by considerable empirical literature, a peculiar feature of initial public offerings (IPOs) is underpricing (i.e., the spike in the price of a share relative to its offering price on the first day of trading). Many theoretical papers have tried to explain why new issues are underpriced. Most of these explanations are based on the existence of some type of asymmetric information in the IPO process. (1) A major empirical implication (Ritter, 1984; Beatty and Ritter, 1986) is that underpricing can be interpreted as a premium for the ex ante uncertainty about firm market value.

Recently, theoretical studies have posited that despite the underwriter's best effort, the degree of uncertainty and informational asymmetry among investors is not completely resolved on the primary market and, instead, remain significant "during the transition to normal secondary market trading conditions" (Chen and Wilhelm, 2008), as proved by the substantial use of price stabilization practices in the immediate aftermath of the offering (we will refer to this period as ex post). In this paper, we develop proxies to measure the amount of ex post value uncertainty. We then investigate the link between ex post value uncertainty and IPO underpricing by employing regressions, which also control for other factors known to be associated with IPO underpricing. We find that including a proxy for ex post value uncertainty more than doubles the explanatory power of previous models that have only considered ex ante uncertainty as the main determinant of IPO underpricing. In particular, including the standard deviation of quote midpoints for several subperiods immediately following the start of trading increases the [R.sup.2] to 0.66. Standardizing the standard deviations by the offering price further increases the explanatory power to 72%.

Related to value uncertainty is a recent paper by Saar (2001). In that paper, the author argues that investor demand uncertainty leads to wider spreads. We find support for Saar's argument. In particular, we find that spreads, on average, narrow from $0.48 to $0.35 within the first four minutes of trading. We also find that, on average, 18.9% of the total number of shares offered trade in the first four minutes after the initial opening.

The remainder of the paper is organized as follows. The next section presents a short review of the literature and develops our hypotheses based on it. In Section II, we describe the data set used to test our hypotheses. Section III describes the empirical results, while Section IV provides our conclusions.

I. Literature Review

Beatty and Ritter (1986) argue that the amount of ex ante uncertainty as to true firm value is the main determinant of the level of underpricing in IPOs. They build on Rock (1986), who interprets underpricing as a premium to uninformed investors for the winner's curse problem they face vis-a-vis informed investors, who observe the true firm value. Beatty and Ritter (1986) further develop this idea by claiming that more ex ante uncertainty aggravates the winner's curse problem and, consequently, requires additional underpricing. They test their theory by using, as a proxy for ex ante uncertainty, the inverse of the gross proceeds raised in the offering as well as the number of uses mentioned in the prospectus. …

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