Adverse Selection Theory And The Theory Of IPO Underpricing

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The first theory of IPO underpricing we examined is Adverse selection theory. This model divides the investors into different groups, informed and uninformed. According to this, the informed investors know the true value of the stock and uninformed investors invest randomly without any knowledge of the company. It also assumes that the investment bank has perfect knowledge of the issuing firms real value and the issuing firm must rely on the investment banks audit for this information. Theory claims that companies intentionally underprice IPOs as a rational behaviour in order to induce the uninformed investors to participate in the market and thereby raising the demand for the issues.
The second theory of underpricing examines the relationship
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The conclusion is that the firm could signal its value to outsiders by retaining its own shares. The percentage of shares retained by the original owners and insiders would signal high value. The hypothesis states that firms will intentionally underprice their issues to grandstand an IPO and to attract attention gained by the large first day run-up in the stock price. Hence, the degree of underpricing would be related to the size of the issuing firm.
In order to assess the theoretical framework for our research proposal, we have to divide it in two distinct parts: the theories based on asymmetric information, and the theories based on symmetric information.
First of all, in the different literature we examined, there is only a theoretical framework for IPO underpricing and not for IPO overpricing. The only reason for that in because, investors in an IPO will only be willing to invest if the share price is bellow the valuation of the issuing firm. Thus the possibility of overpricing is almost equal to zero, as investors will only look for “bargains”.
Theories based on asymmetric
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As a matter of fact, by allowing underpricing, issuing firms would give incentives to potential investors to buy large blocks of stocks. Thus a majority at the board would be easily found and would be beneficial for the firm. A clear majority at the board would permit a better control of the firm’s management team, and thus permit the firm to be more efficient over the long run.
6) Hypothesis development
Basically we examined several hypothesis about the reasons of IPO underpricing. We claimed that the high underpricing in different markets is not driven by insider’s selling behaviour. If the insiders sell a large number of their shares in the IPO, then they should be more concerned about the level of underpricing. Underpricing is caused by the high degree of riskiness of the issuing firms and by the partial adjustment phenomenon of offer prices to compensate institutional investors for the truthful revelation of their demand for the shares.
We also proposed that IPOs are highly underpriced if they are risky and if the offer price is revised

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