Section 3- The model and empirical implications
Introduction:
The effect of sentiment investors has been
advocated particularly strongly for the Initial Public Offerings' patterns,
since by definition, IPO firms have no prior share price history and tend to be
young, immature, and relatively informationally opaque. So they are very
sensitive to the state of mind of the investors and to investors' feelings and
beliefs. A large literature over the past decades, both theoretical and
empirical, has attributed the IPO pattern and the short run IPO puzzle to the
presence of this type of investors.
The works of researchers who are interested in the behavioral
approach and in the investor sentiment explanation to clarify the short run IPO
puzzle and to understand the IPO underpricing anomaly are numerous. The list is
long and is in continuously growth.
I presented in the previous paragraphs the most important
studies and papers that have considered the sentiment explanation and the
investor's behaviour as the most convincing and relevant driver and determinant
of IPO underpricing. I presented the application of the behavioral and
sentiment approach to clarify and to understand the IPO patterns by numerous
researchers to shed light on the importance of the sentiment investors in the
IPO market.
I continue in the same direction of the behavioral approach
and the investor sentiment explanation to the short run IPO puzzle, believing
in the relevance of this explanation to clarify and to understand the
underpricing phenomenon and in the importance of sentiment investors in the IPO
market to explain its anomalies. I presume that there are periods when capital
providers (individual and institutional investors) become irrationally
enthusiastic about new investment opportunities. In this thesis, we are in the
case of the new Initial Public Offerings. They become irrationally overly
optimistic about the IPO market. This over optimism is based on the favourable
recent history of the IPO market and the positive initial returns recently
observed for the new issues. These sentiment investors project this positive
tendency on the recent future, believing that the IPO market will continue in
the same direction in the recent future for sure. This period is known as
«Hot IPO market». The investors' exuberance translates into periods
of high demand for Initial Public Offerings, called «sentiment
demand» since it is based on sentiment and beliefs. It is far from a
perfectly rational demand based on fundamentals, and these sentiment investors
are willing to pay higher prices to have IPO shares. As I presented in a
previous paragraph, the IPO market is cyclical. There are periods of «hot
market», but there are also periods of «cold IPO market» and
sentiment investors become overly pessimistic about IPOs.
There are two types of investors: there are individual or
retail investors and institutional investors who are more informed and
important clients. A question may arise: what type of investors is driving
first day closing prices and the underpricing anomaly?
The empirical works and studies investigating in IPO issue
activity and particularly in the short run IPO anomaly, using the
«traditional explanations» based on the asymmetric or symmetric
theories, or using the behavioral approach and the sentiment explanation, draw
numerous and different conclusions.
The biggest limitation is that none conduct a comprehensive
analysis that evaluates all of the explanations in a systematic manner. None
try to present in the same model all the explanations: asymmetric, symmetric
and behavioral, to determine which is the most relevant and convincing to
explain the short run IPO puzzle, and none try to distinguish between the
sentiment of the two types of investors: individual and institutional, to
verify which type of investors exactly is driving the underpricing anomaly.
In this study, an effort to regroup the most important
explanations that have been advanced in the same model to determine which of
these explanations characterizes best the data in the context of a unified
framework and model. I introduce the three theories:
Ø Asymmetric information
Ø Symmetric information, and
Ø Behavioral approach.
And since there are two types of investors in the IPO market:
individual and institutional investors, one of the goals of this study, is to
identify which type is driving the first day closing prices and underpricing by
distinguishing between the individual investors' sentiment and the
institutional investors' sentiment.
To this end, I use direct measure of sentiment for the two
types of investors and this represents another contribution of this work.
The aim in this thesis is to show how sentiment investors and
their irrationally overly optimism can lead to a first day price run up and
therefore to underpricing, and can explain this short run anomaly with a
distinction between the two types of investors in the IPO market to clarify and
to understand which type is more conducting the short run IPO puzzle, and using
a direct measure of sentiment for each category of investors: the investor
sentiment index.
I- The model and explanatory variables:
I-1\ The model:
As I presented in the previous sections,
there are numerous explanations advanced to understand and to clarify the short
run IPO anomaly. These explanations can be classified in three main
categories:
Ø Explanations based on asymmetric information between
the key IPO parties and have been considered the most convincing explanations
for decades.
Ø Explanations asserting the informational transparency
and lucidity and asserting the IPO market efficiency.
Ø And explanations based on Behavioral Approach and on
investors' sentiments and beliefs.
I regroup the three theories advanced in the same model to
determine which of these explanations characterizes best the data in the
context of a unified model and presents the most relevant and reliable
explanation to underpricing phenomenon. I present every theory by one or more
indicators and determinants.
v For the informational asymmetry theory, I use the firm
quality as a determinant with many proxies: the Overhang Ratio, Venture Capital
backed, Underwriter reputation and R&D intensity.
v For the theory asserting the IPO market efficiency, I use
the risk determinant: age of the issuing firm, firm size (sales and assets),
firm profitability, ROA and the issue risk (if the firm operates in a
technological and risky sector). I use also the issue size (Ln (expected
proceeds)), and the issuer bargaining power.
v Finally, for the behavioral approach, I use direct measures
of investor sentiment, and I distinguish between the two types of investors:
the individual investor sentiment and the institutional investor sentiment. For
this, I use the individual investor sentiment index (AAII) and the
institutional investor sentiment index (II).
The regression model used in this study is as follows:
Underpricing = a0 + a1Underwriter
Reputation Dummy + a2Overhang + a3R&D Intensity +
a4VC Dummy + a5Ln (1+age) + a6Ln (assets) +
a7Ln (sales) + a8Firm Profitability + a9ROA +
a10Issue Risk Dummy + a11Ln (expected proceeds) +
a12Insiders Ownership + a13Institutional Ownership +
a14Blockholders Ownership + a15Individual Investor
Sentiment + a16Institutional Investor Sentiment+ a17Time
Dummy + åi
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