One method utilized by companies to obtain the long-term capital necessary to run and grow their businesses is by providing the general public with the option to purchase stocks. The company's first sale of stock is known as the initial public offering (IPO). When a company first offers the IPO, stocks are, on average, underpriced.
1. Discuss the implications of such underpricing to established theories of market efficiency.
2. Explain the role market efficiency might play in the underpricing theories presented by Loughran and Ritter.
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Underpricing of IPOs
The existence of underpricing has been documented in literature pertaining to finance as it is a common feature of international markets. Although underpricing is a cost to the issuing company it is still undertaken largely (Gregoriou, n.d). Underpricing creates more demand for IPO which is an indicator of success of the IPO.
According to prospect theory (Loughran and Ritter), issuer is more concerned about the wealth rather than its level. When offer price is increased during book-building process as a result of increased public information, issuer of public offering leaves more money on the table for investors. As a result a bargaining model is developed in which if market returns are high the issuer bargains less aggressively with the investment bank for the IPO. Hence it leads to greater underpricing and a lower probability that the IPO would be withdrawn. Favorable public knowledge puts pressure on issuer to price the issue less aggressively. It in turn increases the probability of success of the ...
The solution discusses the underpricing and corresponding theories regarding IPOs.