Finance and Economics Discussion Series (FEDS)
April 2006
A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance
Matthew Pritsker
Abstract:
I present a fully-rational symmetric-information model of an IPO, and a dynamic imperfectly competitive model of trading in the IPO aftermarket. The model helps to explain IPO underpricing, underperformance, and why share allocations favor large institutional investors. In the model, underwriters need to sell a fixed number of shares at the IPO or in the aftermarket. To maximize revenue and avoid selling into the aftermarket where they can be exploited by large investors, underwriters distort share allocations towards investors with market power, and set the IPO offer price below the aftermarket trading price. Large investors who receive IPO share allocations sell them slowly afterwards to reduce their trade's price-impact. This curtails the shares that are available to small price-taking investors, causing them to bid up prices and bid down returns. In some simulations, the distorted share allocations and slow unwinding behavior generate post-IPO return underperformance that persists for several years.
Full Paper (Screen Reader Version)Keywords: Liquidity, IPO, asset pricing, market microstructure
PDF: Full Paper
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.