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Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing

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par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010

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II- Literature review of behavioral explanations:

As I said before, the tendency of behavioral approach and investor sentiment is not a new field not again discovered, the investor sentiment was introduced earlier in the 1990's by Welch who presented the informational cascade theory. But the Behavioral Approach has sparked the academics' attention, has intrigued more and more researchers and has taken all its impetus in this decade. The studies and investigations are more and more numerous trying to explain the short run IPO anomaly by investor sentiment and behaviour. The research effort is continuing since the behavioral approach seems to be a very promising field to resolve the short run IPO phenomenon that is still a puzzle since the other theories and explanations advanced earlier failed to resolve it.

I begin by presenting the first explanations and the first findings that were observed to explain the short run phenomenon by the investor sentiment.

II-1\ Informational cascades:

If potential investors pay attention not only to their own information about a new issue, but also to whether other investors are purchasing or not and they attempt to judge the interest of other investors, according to Welch (1992) 15, bandwagon effects or also known as information cascades may develop:

Later investors can condition their bids on the bids of earlier investors, rationally disregarding their own information. If an investor sees that no one else wants to buy, he may not buy even when he possesses favourable information about the issue: Later investors abstain because earlier investors abstain. In order to prevent this situation from happening, an issuer may have to underprice the IPO to induce the first few potential buyers, and later induce a cascade in which all subsequent investors want to buy irrespective of their own information. They will imitate the first potential investors even if they have unfavourable and negative information about the IPO. Since there are some investors interested in the IPO and bought, other investors will be also interested in the offering and will request shares even if they think that it is unattractive, their opinion will change and they will think that it is a hot offering.

So, if an issuer succeeds the first sales, he is sure that later investors are encouraged to invest in his offering whatever their own information. Conversely, if an issuer fails the first sales to the earlier investors, this will dissuades later investors from investing irrespective to their own information.

In support for this informational cascade explanation, Amihud, Hauser and Kirsh (2001) find that IPOs tend to be either undersubscribed or hugely oversubscribed, with very few offerings moderately oversubscribed.

II-2\ The prospect theory:

Prospect theory, developed by Kahneman and Tversky (1979), asserts that people focus more on changes in their wealth compared to the level of their wealth.

Loughran and Ritter (2002) apply prospect theory of Kahneman and Tversky (1979) to IPO market to argue that issuers are more tolerant of excessive underpricing and that they accept underpricing more than necessary if they simultaneously learn about an aftermarket valuation

15 Welch's cascades model remains one of the least explored explanations of IPO underpricing.

that is higher than expected. They are more concerned with an increase in their future wealth rather than instantaneous and immediate profits. Loughran and Ritter argue that the issuing firm's executives bargain less hard for a higher offer price, if they are seeing a personal wealth increase relative to what they had expected based on the file price range that they have fixed, and this is when the price is revised upwards during the bookbuilding process.

Loughran and Ritter explain more this theory by the fact that insiders of IPO companies consider not only the shares they sell in the IPO, but also those they retain which benefit from the large initial price run-up.

Combining prospect theory reference point with Thaler's (1980, 1985) notion of mental accounting, Loughran and Ritter argue that issuers fail to «get upset» about leaving millions of dollars «on the table» in the form of large first-day returns because they tend to sum the wealth loss due to underpricing with the (often larger) wealth gain on retained shares as prices jump in the after-market. Underpricing and the positive initial return is perceived as a wealth loss under the assumption that shares could have been sold at the higher first-day trading price. If the perceived gain exceeds the underpricing loss, the decision-marker (issuer) is satisfied with the IPO underwriter's performance at the IPO. He is satisfied even if he leaves large amount on the table and he accepts the underpricing even if it is higher than necessary since he can compensate this loss by a larger wealth gain. He can benefit from the first day price run-up since he will sell the shares retained at a higher price which will generate a large profit compensating the loss undergone by underpricing.

Ljungqvist and Wilhelm (2004) use the structure suggested by Loughran and Ritter's (2002) behavioral perspective to test whether CEOs deemed «satisfied» with the underwriter's performance according to Loughran and Ritter's story are more likely to hire their IPO underwriters to lead-manage later Seasoned Equity Offerings. Controlling for other known factors, IPO firms are less likely to switch underwriters for their SEO when they were deemed «satisfied» with the IPO underwriter's performance. This result confirms what has been advanced by Loughran and Ritter (2002) about issuers who are not upset about leaving money on the table and about the tolerance of underpricing believing in a future wealth increase.

Underwriters also appear to benefit from behavioral biases in the sense that they extract higher fees for subsequent transactions involving «satisfied» decision-makers.

So, for the literature review of behavioral explanations, I begin by presenting the findings of the first researchers who tried to introduce the behavioral approach and the investor sentiment, the informational cascade introduced by Welch (1992) and the application of the prospect theory developed by Kahneman and Tversky (1979) to IPO market.

These two theories were the first explanations of the short run IPO anomaly advanced based on behavioral approach and investor sentiment. The research effort is continuing and much investigations and studies are advanced later by the researchers who believe in the behavioral approach and in the importance of sentiment to explain and to clarify the underpricing anomaly and to resolve this persistent puzzle over decades in the IPO market.

The behavioral approach has sparked much academic attention and the research effort has provided numerous analytical advances and empirical insights trying to explain the first day price run up and the underpricing anomaly by the investor sentiment.

The effect of sentiment investors has been advocated particularly strongly for initial public offerings. The short run IPO puzzle could be due to overenthusiasm and over optimism among investors who may be less than perfectly rational. And to study the effect of this type of investors on IPO market and on the short run IPO anomaly, the sentiment should be measured which is a very hard to not say that is an impossible task.

Many proxies have been advanced and proposed in the literature to measure the investor sentiment, or at least to approach it since by its subjective and individual characteristics, sentiment can not be observable, and then many results have been found. We will see all these proxies that have been used to measure the investor sentiment and the findings that have been reached.

So, in the paragraphs that follow, the notion of investor sentiment will be studied by researchers in more detail and will take another direction based on the over optimism and over enthusiasm of sentiment and irrational investors.

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