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How Syndicate Short Sales Affect the Informational Efficiency of IPO Prices and Underpricing

Published online by Cambridge University Press:  19 February 2010

Björn Bartling  and
Andreas Park
Björn Bartling
Affiliation:
Institute for Empirical Research in Economics, University of Zurich, Blümlisalpstrasse 10, CH-8006 Zürich, Switzerland. bartling@iew.uzh.ch
Andreas Park
Affiliation:
Department of Economics, University of Toronto, 150 St. George Street (Max Gluskin House), Toronto, ON M5S 3G7, Canada. andreas.park@utoronto.ca
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Abstract

When a company goes public, it is standard practice that the underwriting syndicate allocates more shares than are issued. The underwriter thus holds a short position that it commonly fills by aftermarket trading when market prices fall or, when prices rise, by executing the so-called overallotment option. This option is a standard feature of initial public offering (IPO) arrangements that allows the underwriter to purchase more shares from the issuer at the original offer price. We propose a theoretical model to study the implications of this combination of short position and overallotment option on the pricing of the IPO. Maximizing the sum of both the profits from their share of the offer revenue and the potential profits from aftermarket trading, we show that underwriters strategically distort the offer price. This results either in exacerbated underpricing when favorably informed underwriters lower prices to secure a signaling benefit, or in informationally inefficient offer prices when underwriters pool in offer prices irrespective of their information.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 2 , April 2010 , pp. 441 - 471
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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