DP3053 Hot Markets, Investor Sentiment and IPO Pricing

Author(s): Alexander P. Ljungqvist, Vikram Nanda, Rajdeep Singh
Publication Date: November 2001
Keyword(s): behavioural finance, hot issue markets, initial public offerings, long-run performance
JEL(s): G24, G34
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3053

Our model of the initial public offering process links the three main empirical IPO ?anomalies? ? underpricing, hot issue markets, and long-run underperformance ? and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000 market for Internet IPOs) to the presence of a class of investors who are ?irrational? in the sense of having exuberant expectations regarding future performance. Underpricing and long-run underperformance emerge as underwriters attempt to maximize profits from the sale of equity, at the expense of these exuberant investors. Underpricing serves to compensate regular IPO investors for their role in restricting the supply of available shares and maintaining prices. The model is shown to be consistent with many aspects of the IPO process. It also generates a number of new empirical predictions.