Recent studies have also documented the impact of public information. They find a
positive link between the “market conditions” prevailing at the time of an offering which
represent public information and its subsequent initial return. Favourable market conditions
predict higher underpricing and vice-versa. Derrien and Womack (2003) show that the initial
returns on IPOs in France in the 1992-1998 period were predictable using the market returns
in the three-month period preceding the offerings. Using U.S. data, Loughran and Ritter
(2002) and Lowry and Schwert (2003) obtain similar results: the initial returns in the first day
of trading for IPOs are predictable using the market conditions prevailing at the time of the
IPOs or at a recent past. Favourable market conditions predict higher initial returns and so
higher underpricing, and critical market conditions predict lower initial returns and lower
underpricing, and for some IPOs negative initial returns and overpricing.
Bradley and Jordan (2002) include the 1999 ‘hot issue’ market in their sample and find that
more than 35% of initial returns can be predicted using public information available at IPO
date. However, Lowry and Schwert (2003) find that the effect is economically small.
These favourable market conditions have an impact on noise traders who will be ready to pay
higher IPO prices. They are assumed to be bullish at the time of the offering since they are
very influenced by market conditions: the more favourable market conditions are, the more
favourable noise traders’ sentiment is and the higher the price that they are willing to pay.
But the mystery and the question that arises automatically is, why underwriters do not
incorporate these favourable market conditions and this favourable sentiment when pricing
the IPO and propose a higher offer price which reduces the underpricing anomaly and the
money threw on the table? Why market conditions and noise traders’ sentiment are only
partially incorporated in IPO offer prices?
The underwriter is not only concerned with the IPO price at the time of offering, but he is also
concerned with the aftermarket behaviour of IPO shares in the short run as well as on the long
run. He is committed to provide costly price support if the aftermarket share price falls below
the IPO price (the issue price) in the months following the offering. Even if the noise traders
are bullish at the time of offering, they can change their attitude in the aftermarket.
And a sharp and rational underwriter with a reasonable attitude should take this into
consideration when pricing the IPO. Derrien (2003) says that the IPO price results from a
trade-off: a higher IPO price increases underwriting fees, but also the expected cost of price
support.
This induces the underwriter to set a conservative IPO price with respect to the short-term
aftermarket price of IPO shares. The underwriter has to incorporate partially the market
conditions when pricing IPO to not face a higher cost of price support if the aftermarket price
falls.
When setting the offer price, we can say that the underwriter is constrained by the cost of
price support if the aftermarket price of IPO shares falls below the issue price (if he
overpriced the IPO shares), but he is also constrained by the lost of IPO market shares if he
sets a very low issue price to reduce the risk of support’s price costs inducing very high
underpricing. In this sense, Booth and Smith (1986) claim that the underwriter’s role is to
certify that IPO shares are not overpriced. Therefore, an underwriter that underprices more
than necessary the IPOs will lose market shares on the IPO market and will lose the issuing
firms’ confidence, this is confirmed empirically by Dunbar (2000), and an underwriter that
overprices the IPO shares will pay high costs of price support. Legal costs may also refrain
underwriters from blatantly overpricing new issues, even though investors’ demand is very
large.
Aggarwal (2000) and Ellis, Michaely and O’Hara (2000) provide evidence that underwriters
intervene to stabilize the price of IPO stocks that exhibit poor aftermarket performance. The
underpricing is important to stabilize the IPO prices to compensate the long run
underperformance of the issues.