Theoretical And Positive Research On IPO Underpricing:an Offering-Risk-Based Approach

The abnormal phenomenon prevailing on stock markets that IPO shares are underpriced is contrary to the efficient market hypothesis. Theoretically, according to the theory of general balance, arbitrage can eliminate abnormal profit and the offering market cannot be unbalanced in the long run, and, consequently, if the price of the new issues on the primary market is decided based on the demand on the secondary market, new issues would not be underpriced.However, empirical study based on data sets from different stock markets unanimously confirmed the existence of the abnormal return for new issues. According to such study, the underpricing of new issues is pervasive on stock markets around the world, and, as a whole, the problem of underpricing on the stock markets of developing countries is more severe than on the stock markets of developed ones.Diverse theoretic explanations to the underpricing of new issues, such as the curse of winners, signaling, dynamic collection of information, aversion of the risk of litigation, the cascade of information, and the structure of equity, have been proposed. However, most empirical study to such theoretic assertions have demonstrated that, although they can rationalize the underpricing of new issues to a certain extent, none of them has general acceptability.The underpricing of IPO issues on Chinese stock markets, measured as the average return for the first day on which the stock is listed, is several times higher than that on the stock markets of developed countries, and is considerably higher than such measure for other developing countries.The abnormally serious underpricing of new issues can hamper the sustained development of Chinese stock market. First of all, the abnormal return of new issues drives a substantial portion of fund to exclusively reserved for new issue underscription, and consiquently reduces the efficiency of capital allocation of the stock market. Secondly, the underpricing of new issues foments such an atmosphere of speculation that investors are only concerned about the allocation of new issues rather than the quality of asset and value of the corresponding corporation. And lastly, the abnormal return of new issues hampers the competition between different intermediaries and gives impetus for them to growth rather than development.Fortunately, in recent years, much reform and innovation have been introduced to Chinese stock market. The split share structure reform has advanced successfully, and the offering mechanism is on the way to a market-oriented one.In such a background of development and reform, undertaking study to the underpricing of IPO issues is helpful to reveal the mechanism of the decision of stock prices, and to accelerate the reform of the system of the offering and pricing of new issues so as to bring the function of pricing and resource allocation of the stock market to a full play.The paper analyzes the behavior of the issuer, the underwriter and the regulator facing the uncertainty of the market demand and the risk of failure in the process of the decision of the offering price and the roles they play respectively, with an approach based on the expected utility function, game theory and other mathematic tools.The paper asserts that, in the process of making a decision about the price of new issues, the issuer, the underwriter, and the regulator are all in face of more or less uncertainty about the future market demand. To simplify the analysis, the paper transforms such uncertainty into a binary distribution, and defines the risk of offering as the quantity of market demand on the offering price being less than the shares offered.The paper undertakes analysis of the behavior of the issuer in the process of the pricing of new issues, and demonstrates that, in face of the risk of offering, the issuer would take the price to clear the market under the low demand state and such price under the high demand state as the only two choices to price the new issues, and choose between them. Under certain condition, it would bring the issuer more expected utility to choose the clearing price for the low demand state, rather than the one for the high demand state, as the offering price, and consequently, if the market turns out bo be high, abnormal return would emerge.The paper analyzes the behavior of the underwriter in the process of price decision, and manifests that, if the commission the underwriter secures from its underwriting activities, and a high offering price leads to a higher risk of failure to sell out offered shares and a loss of good reputation, then the best choice for the underwriter is to choose a price low enough to sell out the offered shares under whatever a demand state, which means that the offering price decided by the underwriter whose commission is constant would bring out abnormal return to subscribers if the market demand turns out to be high. It is also demonstrated that, if the offering commission is proportional to the revenue the issuer obtain through the public offering, then the underwriter must balance the commission increment and the risk of reputation loss. If reputation loss is large enough, it would make the underwriter feel better to choose the clearing price for the low demand state as the offering price.Besides, the paper takes into consideration the asymmetry of information withstanding the market demand and the suitability of pricing among the issuer, the underwriter and the regulator, and formulates a multi-stage game model with the regulator, the underwriter and the nature as players. It is proved that, under certain condition, if the regulator and the underwriter both adopt a tic-to-toe strategy, then the game can reach a Nash equilibrium, which means that abnormal returns would emerge if the market demand turns out to be high.In brief, if there exists the offering risk, then, under certain condition, the issuer, the underwriter and the regulator all have the stimulus to choose or encourage others to choose a considerably low price as the offering price, and consequently, however the right to price new issues is allocated among the issuer, the underwriter and the regulator, the offering price would be choose on a level which could make the market clear if the most undesirable demand state emerged, which contributes to underpricing under the less undesirable demand state.An empirical study based on data from Chinese stock market reveals the existence of severe underpricing of new issues and finds supporting proof for the theoretic analyses of the paper.In conclusion, the paper indicates that, under certain condition, the underpricing of IPO issues is the consequence of the rational choice of the issuer and the underwriter in face of the uncertainty of the future market demand. The factors influencing the extent of underpricing of new issues include The extent to which the market demand is uncertain, the return the issuer draws from the initial public offering besides the booked revenue, the reputation loss the underwriter had to bear if the offering were failed, as well as the severity of the punishment the regulator would inflict upon the responsible parties.The paper proposes that, in order to lower the extent of underpricing of new issues on Chinese stock market, effective measures should be adopted, such as fostering the philosophy and atmosphere of rational investment through strengthened investor education and the development of long-term rational investors including institutional investors, developing a variety of entrepreneur funding means, strengthening the beforehand regulation of the behavior of underwriters and the compliance management of securities companies.