II-2-6\ Price stabilization and partial adjustment:
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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