Why ipos are underpriced

Hence, it can be said that underpricing is a kind of premium that the company has to pay to induce the investors to bet their money on an unknown company. Insider Outsider Theory: The insider-outsider theory assumes that underpricing is the best strategy given the asymmetry. This is because if the issue is underpriced, insiders will buy it because they know its true value.

At the same time, outsiders will buy it thinking that it is at least the fair value. When the market corrects and prices rise, both insiders, as well as outsiders, stand to gain. On the other hand, if the issue is overpriced, then neither insiders nor outsiders would want to buy it.

The bottom line is that even though the underpricing of IPOs might seem like an anomaly, it is not. Deliberately underpricing IPOs is a strategy that has been used by many companies as a marketing tool for their issues. To Know more, click on About Us.

The use of this material is free for learning and education purpose. Please reference authorship of content used, including link s to ManagementStudyGuide. What is Investment Banking? Higher I. At least one paper has found that underpricing is reduced by more than 40 percent when an American bank and American investors are involved. This is attributable to the higher underwriting fees that American investment banks charge. Papers have also found that underwriters who incorrectly underprice their business do lose the chance for future I.

The managerial conflict theory posits that management is the primary cause of the underpricing. In its principal form, the manager conflict theory postulates that management creates excessive demand for I. Alternatively, management allows underpricing to ensure that there are many purchasers of the shares. This means there are no large shareholders created by the I. There is not much evidence to support either form of this theory.

This theory posits that the underpricing is because of American securities laws that impose strict liability on the issuer and underwriter for material misstatements and omissions made in connection with the I. The underwriter deliberately underprices the I.

This theory has not found much support primarily because regulatory schemes in other countries are much laxer yet I. These theories have gained attention in the wake of the technology bubble. One form of this theory posits that either institutional investors or managers gain from taking advantage of retail shareholders who act irrationally or otherwise against their economic interests. And that both institutional shareholders and managers therefore underprice I. A variation of this theory posits that it is the institution that allows this underpricing as a result of its own inability to recognize the loss.

Volume Purnanandam , Amiyatosh K. Oxford Academic. Google Scholar. Bhaskaran Swaminathan. Cite Cite Amiyatosh K. Select Format Select format.

Permissions Icon Permissions. The Review of Financial Studies Vol. Issue Section:. You do not currently have access to this article. That is considerably better than the company's stock price falling on its first day and its IPO being blasted as a failure.

Whether it was underpriced or not, once the IPO debuts the company becomes a publicly traded entity owned by its shareholders. Stock Markets. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

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