Study On Underpricing And Overvaluation Of IPO's Abnormal Initianl Return In China

IPO's abnormal initial return (AIR) has been an anomaly existing in almost all stock markets. In the past sixty years, researchers have provided two explanations for this new issues puzzle. The one is underpricing and the other is overvaluation. This paper analyzes AIR in China from two aspects: underpricing in the primary market and overvaluation in the secondary market. Financial regulations and investment risks due to information asymmetry and the segmentation of equity lead to severe IPO underpricing in the primary market. At the same time, there are strict short sales constraints in the secondary market. Noise traders, including optimistic investors and positive feedback traders, drive the first trading price far away from the intrinsic value, and cause IPO to be overvalued in the secondary market. Using a sample of 520 A-share IPOs during 1998-2003, we decompose AIR into underpricing and overvaluation. The results show that underpricing contributes to the most part of AIR in China. However, overvaluation is also important for explaining AIR. Further empirical research shows that financial regulations are the most important factor affecting IPO underpricing and IPO underpricing decreases with the improvement of the primary market.IPO underpricing is really compensation for investment risk. However, prospect theory is not supported by the empirical results. We use a simple model to describe the behavior of nosie trader in IPO market. Short sales constraints drive the pessimistic investors out of the market. Stimulated by optimistic expectation about the IPO firms, the optimistic investors pay a high premium for IPO firms. The demand from positive feedback traders also contributes to the high premium on the first trading day. The long run performance of IPOs gives further evidence of underpricing and overvaluation. For investors who got IPOs in the primary market at the offer price, the three years cumulative abnormal returns amounts to 127.33%. However, for those investors who bought IPOs at the first day closing price, IPOs underperformed the matched firm by 3.14% and 6.78% respectively after three years. The long run performance of IPOs is negatively related to the IPO overvaluation, investor sentiment and positive feedback risk. Both the pricing efficiency of the primary and secondary market will affect AIR. In order to reduce AIR to a reasonable level, a healthy secondary market is as the same important as a perfect primary market. Moreover, through rebalancing the interest of market players, the removing of segmentation of equity could improve the efficiency of the primary market and reduce AIR.