Phenomenon of Underpricing

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When private companies make the transition to becoming public companies listed on a stock exchange, the phenomenon of underpricing in Initial Public Offerings (IPOs), defined as the difference in the closing price of an offer (finalised offer price) and the closing value of a security on a stock exchange, have been extensively researched and have been found to be pervasive on a global level (Loughran et al, 1994) Various literature exists to establish factors in trying to explain this phenomenon of underpricing through different theoretical frameworks. After delving into these different explanations, examination of Australian IPO literature will follow. Information asymmetry explanations for the underpricing of IPOs dominate the literature. Essentially, these theories hypothesis that the issuing firm are at an informational advantage in comparison to investors. Leland and Pyle (1977) first cited that the risk of this asymmetry lied with investors whereby perceiving the ownership of issues after the offering, along with the use of financial intermediaries can substantially mitigate the gap in information. Chemmanur and Fulgheri (1994) mirror these views, stating the use of an investment banker in an offering significantly reduces the asymmetry when working with issuers of a firm, as they have more favourable information about the firm’s future prospects. Other reputable, high quality firms may use this gap to distinguish their offering from mediocre offerings through a term known as signalling. In doing so, intentional underpricing conveys to the market this quality whilst at the same time preventing “bad value” offerings in emulating their successes. Allen and Faulhaber (1989) along with Grinblatt and Hwang (1989) both contend t... ... middle of paper ... ...derwriting by investment banks to be scrutinised for pricing errors as well as examining whether certain industries in the economy going public are susceptible to greater forecasting errors than others. Also, closer inspection of market-wide conditions can be researched to determine if the pricing errors are persistent over time and whether Australia is benefiting from fixed pricing or needs to look to other methods in bringing companies public through IPOs, especially younger firms with no history as well as firms in the highly specialised fields. It also allows scope to put Benveniste and Busaba (1997) conjectures to be tested. Whilst fixed price offerings are the most common in Australia, bookbuilding offerings are also allowed through ASX Bookbuild Facility. From this, we can potentially research the question; Are Australia’s IPO underwriters underperforming?

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