Rock (1986) assumes that some investors are more informed than are other investors
in general, the issue firm, and its underwriter. There is an imbalance of information between
the potential investors themselves. These better informed investors bid only for attractively
priced IPOs. In the case of unattractive offering, the better informed investors will not
purchase the shares and the uninformed investors will have all shares they have bid for
because they bid indiscriminately. But, these uninformed investors are unable to absorb all the
shares offered, that is why underpricing is necessary to incite informed investors to bid for
this offering’s shares even if they think it is unattractive. The lower offer price will incite
them to try to have the offering’s shares. This underpricing is necessary also to not result in a
negative return for this offering for the uninformed investors, whose capital is needed even
for an attractive offering. They must be protected in IPO market to not lose their capital and
their participation because in the case of attractive offerings, informed investors are also
unwilling to absorb all the shares offered and their demand is insufficient. The uninformed
investors should not fear the IPO market, positive returns are required to protect them and to
ensure a continued participation in IPO market.
In the spirit of Rock (1986), Chowdry and Nanda (1996) develop a model in which price
support is used as a complement to underpricing to reduce the losses supported by uninformed
investors and induce them to participate in the IPO.
In conclusion for the theory of winner’s curse of Rock 1986, which is an application of
Akerlof’s (1970) lemons problem, underpricing is necessary to not lose the capital of
uninformed investors and to incite informed investors to take part of an offering allocation
even if it is unattractive. Pricing too high might induce investors and issuers to fear a winner’s
curse.
In the same sense of inciting informed investors to participate in an unattractive offering,
Ljungqvist, Nanda and Singh (2001) find and explain underpricing by the fact that noise
traders cannot absorb the entire IPO because they are wealth constrained. To induce rational
investors to participate in the offering, issuers must set the IPO price below the price noise
traders are ready to pay, to induce underpricing and to make the offering attractive for the
rational investors. These better informed investors can sell the shares to the irrational
investors in the aftermarket and make a profit.
Rock’s (1986) winner’s curse model turns on information heterogeneity among investors.
Michaely and Shaw (1994) argue that as this heterogeneity goes to zero, the winner’s curse
disappears and with it the reason to underprice.
Tore Leite (2007) in his article “Adverse selection, public information and underpricing in
IPOs” finds that favourable public information (such as high market returns) reduce the
winner’s curse problem. And this induces the issuer to price the issue more conservatively in
order to increase its success probability. The author finds a positive relation between public
information and underpricing.