Let’s begin by the risk premium explanation. Because the hot market can end
prematurely, the sentiment demand may cease and then we face a market crashing, carrying
IPO stocks in inventory is risky.
Ljungqvist, Nanda and Singh (2003) in their article: “Hot market, investor sentiment and IPO
pricing” argue that underpricing emerges as fair compensation to the regulars for expected
inventory losses arising from the possibility that the hot market ends prematurely. If the
demand is small (in comparison to the issue offer), the issuer needs the regular investor to
hold inventory. So long as the hot market persists, the regular investor sells this inventory to
newly arriving sentiment investors, but the problem arises if the hot market ceases and the
regular investor is then left with shares priced at the fundamental value (which is less than the
offer price).
The issuer underprices the stock to compensate the regular investor for bearing the risk of an
uncertain sentiment demand. It is a fair payment for the regular’s expected loss. It is a way of
compensating the regular investor for taking on the risk of hot market crashing.
However, Ritter and Welch (2002)(7) refute this explanation since they argue that if the
underpricing is simply a compensation for bearing a systematic or liquidity risk, why do
second-day investors not seem to require this premium, after all fundamental risk and
liquidity constraints are unlikely to be resolved within one day.
As a conclusion for the risk premium explanation based on Ritter and Welch (2002) point of
view, we can say that this explanation is refuted and can not be considered as a relevant and a
convincing explanation for the underpricing anomaly.
7 Ritter and Welch (2002): “A review of IPO activity, pricing, and allocations”.