What is it about?

In Rock (1986), underwriters price IPOs such that they are able to take advantage of naïve investors. In stated respect, IPOs that are highly underpriced - IPOs which incorporate a large differential between the IPO price and the closing price for the newly listed stock at the end of the first day of trading - are representative of underwriters' efforts for taking advantage of naïve investors. Importantly, absent any mathematical proof, Rock (1986) assumes presence of a trade-off between IPO prices and IPO underpricing. In context of the hypothesis, sophisticated investors gain access to IPOs in primary markets then bid up stock prices on the first day of trading in the secondary market for arrival at the overpricing of the newly listed stock. Given then that underpricing coincides with overpricing, but also with sub-optimally low realizations for IPO prices, sophisticated investors and underwriters gain on both sides of the IPO transaction, that is, in each of primary and secondary markets (it is easier for underwriters to fulfill their obligations to issuers if IPOs are priced sub-optimally low). Concurring with Rock (1986), Chemmanur and Fulghieri (1994) hypothesize that the highest realizations of IPO underpricing accrue to the lowest quality IPOs. In presence of the puzzling nature of the time series of IPO underpricing, Pastor and Veronesi (2006) characterize the evolution of IPO underpricing to be a puzzle. In the same vein, Ritter and Welch (2002) assert the demand for studies of the IPO allocations of underwriters with a view to ascertaining whether the management of IPO issues by underwriters has credibility. Since macroeconomic risk evolves, such that the risk associated with the issuance of IPOs does not remain constant over time, necessarily IPO underpricing evolves over time. In stated respect, it is well known that IPO underpricing is highest in the context of stock market booms and lowest in the context of stock market busts. If then a study of the credibility of the underwriting of IPOs is to have robustness, there is arrival, necessarily at demand for a metric which adjusts the realizations of IPO underpricing, such that they all are comparable. This study arrives at exactly such a metric, that is, a 'measure'. A measure differs from a proxy in the sense that it has formulation as a concept for which feasibly there exist many different proxies. In stated respect, conditional on the directionality of the changes to macroeconomic risk, this study arrives at a measure for the directionality of IPO underpricing. For the specific purposes of the current study, the proxy for the measure is derived from the 'HML' factor of the Fama and French (1993) three factor asset pricing model. The resulting proxy, termed HMLd virtually is perfectly orthogonal to the HML factor and is shown to be a robust proxy for the intertemporal variability of IPO underpricing. A link to the STATA code for the generation of HMLd from HML is available on this page. If study findings are to be robust, there exists the need of a robust proxy for the reputation of underwriters. Whereas there exists internally consistent evidence, to wit, IPO volume is a proxy for underwriters' reputation, this study provides the first exogenous evidence - evidence which is not restricted solely to the parameters of IPOs - that IPO volume is a proxy for the reputation of underwriters. For concreteness of the new insight, whereas inclusive of Pastor and Veronesi (2005) none of prior studies decipher the structural relation that subsists between IPO underpricing and IPO volume, this study shows IPO underpricing is a well defined, structural non-linear function of IPO volume. Consistent with the hypothesis, to wit, the underwriting of IPOs has credibility, the non-linearity mostly is induced by the most reputable underwriters (see Figures 1 and 2 of the study).

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Why is it important?

If the underwriting of IPOs is lacking in credibility, IPO valuations all are lacking in credibility and the demand for 'fairness' in the context of the allocation of society's resources across IPO issuers - the essence of underwriting - is defeated. Given IPO valuations that are lacking in credibility revert necessarily and in eventuality to more credible stock valuations in secondary equity markets (in response to new information), there is arrival at stock markets which, in the course of the search for fairer prices become extremely volatile, resulting in increases to the probability of losses. In light of the foregoing, the credibility, or otherwise of the underwriting of IPOs has implications, not only for investors, but also for all of society. The rationale is, of course straightforward, namely for most of society, welfare in retirement is, to a large degree, a function of investments in stock markets. Study findings exonerate underwriters, not as to the numerical valuations that are arrived at for IPOs, but as to the 'fairness' of the pricing of the IPOs. In stated respect, study findings show it is the highest quality IPOs, as opposed to the lowest quality IPOs that are most highly underpriced. Coupled with, the formal theoretical prediction in Obrimah (2022) that higher quality IPOs are associated with each of higher IPO prices and the highest realizations of IPO underpricing (Rock 1986 proposes a trade-off between prices and underpricing); corroborating empirical findings in Purnanandam and Swaminathan (2004) that higher underpricing is accompanied by higher IPO prices; and the finding, in this study that IPOs that are most highly underpriced are estimated, ex ante, that is, prior to the determination of IPO underpricing, to be the lowest risk IPOs, there is arrival at fairness of the pricing of IPOs. The concreteness of study inferences is evident as follows. Suppose a good state of the world, that is, a state in the context of which assessments of the quality of IPOs are not murky. In such states of the world the most reputable underwriters focus on the underwriting of the highest quality IPOs in the existing sectors. Suppose, however, a murky state of the world, that is, a state in the context of which a new innovation, equivalently new sector has arrived in an economy and the firms in the sector are seeking listings in stock markets, but as yet there is some murkiness as to the metrics that are most robust to the ascertainment of their quality. In such states of the world, study findings show, explicitly, that the most reputable underwriters switch their focus to the underwriting of this new class of IPOs, as such leave some of the underwriting of high quality IPOs whose businesses are domiciled in sectors that already are well established to less reputable underwriters. Clearly, there is arrival at an equilibrium which enhances the socioeconomy, to wit, a socioeconomy in the context of which the very best skills are directed to the most challenging tasks.


In Obrimah (2016), I develop a formal theory which predicts, conditional on the arrival of new innovations in real sectors, that the most reputable underwriters transition away from the underwriting of IPOs that do business in established sectors, to the underwriting of IPOs whose businesses are domiciled in the newly emergent innovative sector. Empirical findings that are obtained in this study validate the stated formal theoretical prediction and produce the important insight, to wit, the reputation of an underwriter is not robustly decipherable from the underpricing of it's IPOs at any one specific point in time. On the contrary, always the reputation of an underwriter robustly is deciphered only in the context of the qualitative parameters for the intertemporal evolution of the underpricing of it's portfolio of IPOs.

Dr Oghenovo A Obrimah
Fisk University

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This page is a summary of: Underpricing of initial public offerings (IPOs) and the credibility of underwriters’ pricing services, SN Business & Economics, January 2023, Springer Science + Business Media,
DOI: 10.1007/s43546-022-00415-y.
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