Academic journal article IUP Journal of Applied Finance

Risk Proxies and IPO Underpricing: An Empirical Investigation

Academic journal article IUP Journal of Applied Finance

Risk Proxies and IPO Underpricing: An Empirical Investigation

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Initial Public Offerings (IPOs) involve more pricing uncertainty than the existing listed equities. The non-availability of price history and published information makes it more difficult to directly measure the magnitude of risks surrounding an IPO. Instead, the level of underpricing (initial day return) serves as a useful proxy for estimated market risk for the IPOs. The relationship between expected return and perceived risk level for IPOs is well documented in the literature (Welch, 1992; Ljungqvist and Wilhelm, 2002; and Loughran and Ritter, 2004). Ritter (1984) and Beatty and Ritter (1986) explained that there exists a positive relationship between underpricing and ex ante uncertainty. They argued that when investors bid for IPOs, they implicitly invest in a call option. This option becomes more valuable only when the post-issue price is more than the offer price. In other words, the value of this option increases when uncertainty in the share price increases.

Underpricing not only reflects the uncertainty surrounding the IPO at offer, but also indicates the after market variance (Gleason et al., 2008). In finance theory, standard deviation of after market return is commonly used as a measure of risk. By convention, the standard deviation of after market returns for initial 20 trading is used as proxy for ex ante uncertainty. However, the use of ex ante as risk surrogate has little explanation power (Johnson and Miller, 1988). More recent studies were found to use a different set of risk proxies while evaluating underpricing, i.e., investment bank prestige, age of the firm, offer size, Parkinson's extreme value measure1 and debt equity ratio at IPO date. Besides the above risk, a surrogate, the IPO firm also publishes a list of risk factors in the issue prospectus. Since many factors have been used as proxies for risk measures, the following questions explain the focus of this paper: (a) Since risk has a positive effect on initial day return, is it that important and valid in our research? (b) Which risk proxy has better explanation for underpricing? and (c) Assessing whether risk proxies are uniformly distributed across industry sectors.

The primary purpose of this paper is to identify the most suitable risk proxy for an IPO. We compare the significance of ex ante uncertainty with other risk surrogates, i.e., investment bank prestige, age, offer proceeds, listing day high price scaled by low price (H/L) and debt ratio at IPO date. Moreover, we attempt to evaluate the suitability of Parkinson's extreme value measure as proxy for risks and uncertainty contiguous to IPOs. This study also aims to provide an insight into the variability of estimation efficiency of risk proxies across the industry. Our analysis also intends to reveal the relationship between these risk proxies and short-term reaction of the investors.

We find that H/L explains a large portion of underpricing than other risk surrogates, suggesting that after market price range has superior explanatory power for uncertainty surrounding an IPO. Besides H/L, investment bank prestige and inverse of offer proceeds have a statistically significant impact on underprice. However, the most surprising outcome of the study indicates that both ex ante and age of the IPO firm are statistically insignificant in explaining underprice. Moreover, we studied the predictive behavior of the risk proxies across manufacturing and non-manufacturing sectors. H/L, investment bank prestige and age of the IPO firm were found suitable risk proxies for the manufacturing sector, while the risk for non-manufacturing sector was significantly represented by H/L, investment bank prestige, inverse of offer proceeds, and after market volatility.

The study contributes to literature by investigating the suitable risk proxy for the uncertainty surrounding the IPOs. Alternatively, we attempt to find the relative predictive power of various risk proxies for IPO underprice. …

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