Cornelli, Goldreich and Ljungqvist (2004) try to take advantage of the existence of a
grey market in Europe to construct a model on European Initial Public Offerings to look at
whether the presence of sentiment investors affects prices in the post-IPO market and whether
investors’ sentiment can explain and be considered as a driver and primary determinant of
underpricing anomaly.
Before going in details and presenting the findings of these authors, I should begin by
defining the grey market and presenting some assumptions in their model to understand their
results.
The Grey Market is a when-issued market for shares to be issued in an IPO (the
definition as given by the authors).
Most European countries have grey markets for IPOs. It is a Pre-IPO market taking place at
the same time as institutional bookbuilding (before setting the issue price definitively). In this
market, retail and smaller investors speculate on the post-IPO share price, so these investors
are trading IPOs before they are listed on the stock market. The prices at which they speculate
are considered as post-IPO share prices and that is why the grey market is considered as an
opportunity to observe the post-IPO prices and the opinion of small investors and to foresee
their behaviour in the after market. The grey market is an opportunity to foresee what it will
be in the IPO after-market. It is the unique opportunity to observe the valuation of the
investors who will be buying shares in the aftermarket and to measure the expectations of
sentiment investors directly. It is also beneficial to the issuers to increase the offer price and
then the IPO proceeds. In the U.S, regulations prohibit the existence of Grey Markets and the
speculation of IPO shares before they are listed on the stock market.
The assumptions used by the authors in this article are the following:
The grey market investors may overweight the relevance of their information, so the authors
allow for the possibility that grey market investors are sentiment investors but they do not
impose it.
When the publicly observable grey market price is high relative to fundamental value,
bookbuilding investors resell shares to these smaller investors in the aftermarket, so the offer
price and the aftermarket price will be close to the grey market price. In contrast, when the
grey market price is low, the offer and aftermarket prices will be close to fundamental value.
Because the fundamental value is unobservable, econometricians usually take the midpoint of
the initial indicative price range as a proxy for fundamental value.
The dataset consists of 486 companies which went public in twelve European countries
between November 1995 and December 2002 and for which there exist grey market prices.
To give a valuation to the investor sentiment, the authors use the normalized last grey market
price before the issue price was set: PGM / P mid (the midpoint of the initial indicative price
range). They find that there is a positive correlation between grey market price, issue price
and aftermarket price. The grey market price is more correlated with the issue and the
aftermarket prices when the grey market price is high, although there is a positive correlation
even when the grey market price is low. So this positive correlation confirms the fact that the
presence of sentiment investors has an impact on after market prices and so on the
underpricing anomaly.
In conclusion, Cornelli, Goldreich and Ljungqvist (2004) find that high pre-IPO
prices, which indicate overly optimistic investors, are a good predictor of high initial returns
during the first trading day. And then, the high investor sentiment valued by high grey market
prices, is a primary driver and determinant of the short run IPO anomaly.
When small investors are excessively optimistic, they are willing to pay a price above the
fundamental value, resulting in a high aftermarket price (foreseen through the grey market
prices), and so in underpricing. But when these sentiment investors are pessimistic about an
issue, their opinion has less of an effect on the aftermarket and issue prices that will be close
to the fundamental value and not to the grey market, which suggests that the underwriter and
sophisticated investors can identify sentiment investors. Thus, they consider the opinion of
sentiment investors biased, and they take it into account only when they can profit from it, by
selling shares to them in the aftermarket.
Cornelli, Goldreich and Ljungqvist (2004), are not the first authors using the grey market in
their study to value the investor sentiment trying to explain the short run IPO anomaly. There
are other earlier studies that are complementary to the findings of these authors. For example,
Dorn (2003) finds that the volume of grey market trading among the customers of a German
retail brokerage is correlated with high initial returns and low long-run returns. This can be
viewed as further evidence that participation by smaller investors in the grey market can be
interpreted as sentiment. Besides Dorn (2003), two other papers study the grey market in
Germany: Loffler, Panther and Theissen (2002) document that grey market prices are
unbiased estimates of first-day prices. Aussenegg, Pichler, and Stomper (2003) also find that
IPO offer prices are related to prices in the grey market but they show that the coefficient is
smaller than one. Finally, Pichler and Stomper (2004) model the interaction between
bookbuilding and the grey market when grey market investors have similar information to
bookbuilding investors. They ask whether the existence of a grey market helps or hinders
information aggregation in bookbuilding. In contrast, Cornelli, Goldreich and Ljungqvist
(2004), introduce a class of investors who have different information from bookbuilding
investors, in order to explain certain IPO phenomena and to show how these (possibly biased)
investors affect prices.