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”.
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