Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
Recent studies have also documented the impact of public information. They find a positive link between the «market conditions» prevailing at the time of an offering which represent public information and its subsequent initial return. Favourable market conditions predict higher underpricing and vice-versa. Derrien and Womack (2003) show that the initial returns on IPOs in France in the 1992-1998 period were predictable using the market returns in the three-month period preceding the offerings. Using U.S. data, Loughran and Ritter (2002) and Lowry and Schwert (2003) obtain similar results: the initial returns in the first day of trading for IPOs are predictable using the market conditions prevailing at the time of the IPOs or at a recent past. Favourable market conditions predict higher initial returns and so higher underpricing, and critical market conditions predict lower initial returns and lower underpricing, and for some IPOs negative initial returns and overpricing.
Bradley and Jordan (2002) include the 1999 `hot issue' market in their sample and find that more than 35% of initial returns can be predicted using public information available at IPO date. However, Lowry and Schwert (2003) find that the effect is economically small.
These favourable market conditions have an impact on noise traders who will be ready to pay higher IPO prices. They are assumed to be bullish at the time of the offering since they are very influenced by market conditions: the more favourable market conditions are, the more favourable noise traders' sentiment is and the higher the price that they are willing to pay.
But the mystery and the question that arises automatically is, why underwriters do not incorporate these favourable market conditions and this favourable sentiment when pricing the IPO and propose a higher offer price which reduces the underpricing anomaly and the money threw on the table? Why market conditions and noise traders' sentiment are only partially incorporated in IPO offer prices?
The underwriter is not only concerned with the IPO price at the time of offering, but he is also concerned with the aftermarket behaviour of IPO shares in the short run as well as on the long run. He is committed to provide costly price support if the aftermarket share price falls below the IPO price (the issue price) in the months following the offering. Even if the noise traders are bullish at the time of offering, they can change their attitude in the aftermarket.
And a sharp and rational underwriter with a reasonable attitude should take this into consideration when pricing the IPO. Derrien (2003) says that the IPO price results from a trade-off: a higher IPO price increases underwriting fees, but also the expected cost of price support.
This induces the underwriter to set a conservative IPO price with respect to the short-term aftermarket price of IPO shares. The underwriter has to incorporate partially the market conditions when pricing IPO to not face a higher cost of price support if the aftermarket price falls.
When setting the offer price, we can say that the underwriter is constrained by the cost of price support if the aftermarket price of IPO shares falls below the issue price (if he overpriced the IPO shares), but he is also constrained by the lost of IPO market shares if he sets a very low issue price to reduce the risk of support's price costs inducing very high underpricing. In this sense, Booth and Smith (1986) claim that the underwriter's role is to certify that IPO shares are not overpriced. Therefore, an underwriter that underprices more than necessary the IPOs will lose market shares on the IPO market and will lose the issuing firms' confidence, this is confirmed empirically by Dunbar (2000), and an underwriter that overprices the IPO shares will pay high costs of price support. Legal costs may also refrain underwriters from blatantly overpricing new issues, even though investors' demand is very large.
Aggarwal (2000) and Ellis, Michaely and O'Hara (2000) provide evidence that underwriters intervene to stabilize the price of IPO stocks that exhibit poor aftermarket performance. The underpricing is important to stabilize the IPO prices to compensate the long run underperformance of the issues.
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