Loughran and Ritter (2004) use many measures of risk: the natural logarithm of the
assets and the natural logarithm of the sales which reflect the issuing firm size and then a risk
related to valuation uncertainty, internet and tech dummy variables which reflect
technological uncertainty which also induces a valuation uncertainty, and the natural
logarithm of one plus the age (years since the firm’s founding date to the date of going public
and the date of introduction in IPO market) which reflect the age of the issuing firm. For a
sample including 5,990 US operating firm IPOs over 1980-2003, they find a positive relation
between risk and underpricing.
If the issuing firm is risky from the investors’ point of view, it can not be introduced in
the market at a higher price because it will not be accepted by these investors who are
dissuaded about the risky IPO shares. The offer price is set at a lower level to incite investors
to purchase the IPO stocks even if they think it to be risky.
The risk composition hypothesis, introduced by Ritter (1984), assumes that riskier IPOs will
be underpriced by more than less-risky IPOs. Riskier firms set a low offer price to incite
investors to participate in the IPO market and to buy the IPO risky shares, and then the
underpricing will be higher. For example, young firms are riskier and the internet bubble
period saw a high proportion of young firms going public and a high percent of underpricing,
which can confirm the explanation of risk.
In the same direction of the risk, we can also talk about the uncertainty level introduced by
Beatty and Ritter (1986). They relate the level of ex-ante uncertainty surrounding the intrinsic
value of an IPO to the level of underpricing. The higher the uncertainty level about the
intrinsic value of the IPO, the higher is the level of underpricing. It reflects the valuation
uncertainty.
Besides, Bartov, Mohanram and Seethamraju (2003) report that a dummy variable for risky
IPOs has no effect on the setting of the final offer price, providing evidence for the argument
that risk might not be that important for the pricing of IPOs. So there is no correlation
between risk and underpricing. The notion of risk can not explain the setting of a lower offer
price and then the underpricing phenomenon. This important finding refutes the prior
researches and results about the suitability of the risk as an explanation to the underpricing
anomaly. Risk can not be considered as a convincing explanation to the short run IPO
anomaly since it has no effect on the setting of a lower offer price, and then underpricing is
not induced by risk.