The list of proxies used by researchers to value investor sentiment and to study its
impact on underpricing anomaly is very long. I presented the most important proxies in the
previous paragraphs: grey market prices, market conditions, demand submitted by individual
investors and discounts on closed-end funds.
In the present paragraph, I try to give a brief sight on the other proxies that are used by
researchers and the main results found:
Rajan and Servaes (2003) model two different types of irrational agents, feedback
traders and sentiment investors. They proxy for investor sentiment using the market-to-book
ratio and find that it correlates positively with first-day returns and negatively with long-run
returns. So there is a positive correlation between investor sentiment valued through marketto-
book ratio and underpricing phenomenon.
Other studies have looked at who owns the shares in the aftermarket: for example,
Ofek and Richardson (2003) show that high initial returns occur when institutions sell IPO
shares to retail investors on the first day.
Similarly, Ben Dor (2003) looks at the level of institutional ownership shortly after the
IPO and finds that high institutional ownership forecasts higher returns in “hot” markets.
So, these authors use another proxy to investor sentiment: the holdings of large (institutional)
investors. Since these institutional investors have the possibility to sell the IPO shares to
sentiment investors in the aftermarket in the first day of trading(18).
The proxies for sentiment are numerous like the holdings of large (institutional)
investors, put-call ratios, trading volume, market-to-book ratio, market conditions, grey
market prices, closed-end fund discounts, and the list is not exhaustive. There is an ongoing
inconclusive debate about the effectiveness and explanatory power of many investor
sentiment measures (Qui and Welch, 2004).
Oehler, Rummer and Smith (2005) in their article “IPO Pricing and the Relative
Importance of Investor Sentiment-Evidence from Germany” try to explain the persistent
pattern of high initial returns during the first trading day. They focus on the importance of
investor sentiment and of information gathered by the underwriter before the start of the
bookbuilding process. From their viewpoint, there are only two different but not mutually
exclusive scenarios which could lead to the observable pattern of high initial returns at the
first trading day. First, it could be possible that the offer price is set too low due to ex-ante
uncertainty about the true market value of the IPOs. Second, the offer price might be on
average at a “fair value” but demand for new issues is overly high and therefore generating
the observed high initial returns. They conclude from the estimations realized that
underpricing is mainly influenced by investor sentiment and, therefore, by the uncertainty
about the demand of potential investors (the 2nd scenario), and less by ex-ante uncertainty
about the underlying firm’s value. Investor sentiment has the dominant influence on the
fluctuations of initial returns and IPO underpricing anomaly.
To value the ex-ante uncertainty about the potential demand and the investor sentiment, they
focus first on the bookbuilding price range and the subscription period which are set by the
underwriter after observing the potential demand for the stock to be issued, and second on the
explanatory power of pre-IPO trading, stock market performance prior to the issue and the
usage of the so-called Greenshoe option.
In Europe, the length of the bookbuilding period and the width of the bookbuilding range are
set after a pre-marketing period. During this time span IPO research from sell-side and buyside
analysts is produced and distributed by syndicate members to institutional clients
(Jenkinson, Morrison and Wilhelm, 2005). As a result, the length of the subscription period
and the width of the bookbuilding range are good indicators of how strong the underwriter
expects potential demand to be. The longer the subscription period and the wider the initiative
price range, the more uncertain is the underwriter about possible success and the higher is the
uncertainty about potential demand inducing the importance of investor sentiment which
plays a dominant role in influencing the demand. This view is supported by the argument of
Jenkinson, Morrison and Wilhelm (2005) who assert that ceteris paribus less available
information will lead to an increase in the bookbuilding range.
The authors run regressions with the indicative price range and the subscription period as
dependent variables, and find that positive sentiment for IPOs reduces uncertainty about
potential demand and then reduces the subscription period and bookbuilding price range.
To value investor sentiment, Oehler, Rummer and Smith (2005) use many proxies: buy-andhold
on the market prior to the IPO which covers a period of 30 days (market movement),
Grey market trading prices, business climate over the period of one month prior the IPO,
usage of the Greenshoe option which consists in issuing extra shares due to excess demand,
and issue volume (number of issued shares including the exercised Greenshoe multiplied by
issue price). The authors come to the conclusion that investor sentiment and demand have the
dominant influence and impact on initial returns on the first trading day and thus using many
proxies for sentiment which they find very significant in their results. It is changes in investor
sentiment which have the dominant influence on the fluctuations of initial returns.
They also find another important result that the length of the subscription period and width of
the bookbuilding range have negative effects on underpricing.
Aggarwal, Krigman, and Womack (2002) introduce another explanation to first day
IPO anomaly. They relate the aftermarket price path to momentum traders. They focus on the
role of research analysts and the media in creating momentum and in inducing high investors’
sentiment. So to value the investors’ sentiment, they focus on the role of media and research
analysts: when they are important and favourable to the issuing company and to the IPO, this
induces high and positive sentiment among individual investors, and then initial returns are
higher and underpricing is more important.
18 High institutional ownership shortly after the offering is indicating the presence of high and optimistic sentiment among individual
investors, and so institutional investors (rich-information investors) can easily sell the shares to these sentiment investors and making large
incomes and profits.