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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-5\ The use of market conditions to value investor's sentiment:

François Derrien (2003) explores the impact of investor sentiment on the pricing and aftermarket behaviour of IPOs, using a sample of 62 initial public offerings realized on the French stock exchange between 1999 and 2001. He tests a model in which the first day closing price of IPOs and then initial returns and underpricing are depending on the information about the intrinsic value of the company (revealed by institutional investors and it is private information) and on investor sentiment. These French offerings used a unique IPO mechanism: a modified book-building procedure in which a fraction of the IPO shares is reserved for individual investors. This mechanism was created in 1999 and is unique to the French stock exchange: the Offre à Prix Ouvert (OPO).

To value the investors' sentiment, Derrien focus on these individual investors' demand which is related to the market conditions. These individual investors are typically small and uninformed, that is why they are considered as sentiment investors and their demand is a direct measure of sentiment.

The demand for IPO shares submitted by individual investors varies considerably and is strongly and positively related to a measure of market conditions prevailing at the time of the offering. When these conditions are favourable, the investor sentiment is high and individual investors seem to be overly optimistic, presenting a large demand for IPO shares. This demand surely influences IPO prices and then the underpricing phenomenon to a large extent. It leads to high IPO after market prices and then to large initial returns: the more favourable market conditions, the larger the individual investors' demand, the higher the investor sentiment and the higher after market prices, keeping everything else constant.

Loughran and Ritter (2002) and others have provided indirect empirical evidence of this short run IPO phenomenon using various measures of market conditions as proxies for investor sentiment. For example, to measure the market conditions, the return of the industry index the IPO company belongs to in the recent period preceding the offering can be used. Loughran and Ritter use the three week period. But in this paper, the author uses a direct measure of the investor sentiment, namely the demand for IPO shares posted by individual investors in the French IPOs used in data, these investors are considered as sentiment investors and so their demand is a direct measure of sentiment.

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: in that 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.

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, the relation between underpricing and market conditions (market returns) is statistically but not economically significant.

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