1.      What is IPO?  

Answer: IPO refers to the Initial Public Offering, which means that a private company for the first time issues publicly traded shares of stock.

Reasons for going Public:  The market condition is the most important factor in the decision to go public, while the stage of firm in its life cycle is the second important factor (Ritter&Welch, 2002).

2.      What is underpricing?

Answer: First documented by Logue(1973) and Ibbotson(1975), underpricing refers to the pattern of positive average initial returns, which is the percentage price change from the offering price to the closing market price shortly after public trading begins. .(Ljungqvist, 2004)

3.      How about short term performance

Evidence

Although it varies among countries, the phenomenon of average initial returns being positive and economically significant exists with variation in every nation’s stock market. Since the 1960s, the underpricing discount has averaged around 19% in U.S (Ljungqvist, 2004)

Explanations:

(1)   Asymmetric information theories: one of the IPO transaction parties knows more than the others.

a)      winner’s curse ( Rock,1986)): some investors are better informed than others and so can avoid overvalued IPOs. The resulting winner’s curse experienced by uninformed investors has to be countered by deliberate underpricing.

b)      Baron (1982): the underwriter is better informed about demand conditions than the issuer, leading to a principal-agent problem in which underpricing is used to induce optimal selling effort.

c)      Information Revelation (Benveniste and Spindt (1989)),  assume that underpricing compensates better-informed investors for truthfully revealing their information before the issue price is finalized.

d)     Welch (1989):the issuer is better informed about its true value, leading to an equilibrium in which higher-valued firms use underpricing as a signal.

(2)   Institutional theories focus on three features of the marketplace: litigation, banks’ price stabilizing activities once trading starts, and taxes.

·         avoiding legal liabilities(Logue(1973) Ibbotson(1975))

·         bank’s price stabilization (Rudd(1993))

·         taxes arguments(Rydqvist(1997))

(3)   Control theories:  shape the shareholder base so as to reduce intervention by outside investors.

-Brennan and Franks (1997) argue that underpricing helps entrench managerial control, avoiding outsider’s mornitoring, but w/t strong evidence.

-Stoughton and Zechner (1998): underpricing minimizes agency cost by encouraging monitioring.

(4)   Behavioral theories: a) ‘irrational’ investors overvaluate IPOs(Ljungqvist et al, 2004), or b)In ‘information cascade’(Welch,1992),  successful initial sales generate + signals to followers . Prospect theory and mental accounting (Loughran and Ritter, 2002), firms are complacent b/c postmarket valuation is actually higher than firms’ expectation.

4.      IPO’s long term performance

A.    Evidence

Long-run performance of IPO has been the most controversial area of IPO research.

Efficient markets proponents argue that the after-market stock price should appropriately reflect the shares’ intrinsic value and should not be predictable, while researchers favor the behavioral point of view of IPOs underperform in the long run.

Ritter & Welch (2002) point out that the long-run performance of IPOs varies over time. Three-year market-adjusted buy-and-hold returns are negative in every subperiod, but not for every cohort year. Style-adjusted buy-and-hold returns are not as reliably negative, having positive returns. They also believe that there are some problems in measuring the long run performance of IPOs and caution is necessary. First, They find that, the underperformance results are sensitive not only to econometric methodology, but also to the choice of sample period.   Second, Fama-French multifactor regressions can produce very odd results.  

B. Major Explanation about long run underperformance

1) Miller (1977) assumes that there are constraints on shorting IPOs, and that investors have heterogeneous (optimistic and pessimistic) expectations regarding the valuation of a firm. Over time, the marginal investor’s valuation will converge towards the mean valuation, and the stock’s price will fall.

2) Schultz (2001) argues that more IPOs follow successful IPOs. Thus, the last large group of IPOs would underperform but carry a large weight, thus, result in underperformance on average.

 Jain and Kini (1994) and Mikkelson, Partch, and Shah (1997) document that long-run return performance is also accompanied by poor financial accounting performance post-IPO relative to pre-IPO performance and/or industry conditions.

1.       (1) Some Ph.D students proved that stock returns are auto-correlated. Is this a violation of market efficiency?

(2)  Assuming CAPM, and auto correlation, is it a violation or not?  if it is not, why? If it is, how can investors get the abnormal return.

Answer:

(1)   Market efficient hypothesis states that when the market is in the weak form efficiency, the market price has fully reflected historical information. In other words, in an efficient market, the correlation of stock returns is expected to be zero and the price movements are like random walk. However, some discrepancies do NOT necessarily mean violation of market efficiency. Assuming there is no data contamination, we need to consider at least the following reasons:

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1)      Joint-hypothesis problem, or ‘bad model’ problem:  First, any EMH test always is a joint test of the market efficiency and an asset pricing model (Fama(1970)). We don’t know exactly a departure is due to market inefficiency or due to mis-specified asset-pricing model with omitted variables. We need test the robustness of those detected correlations in different models.

2)      Economic significance: Some noted departures are not exploitable after transaction costs are taken into consideration (Fama, Blume (1968)).

3)      nonsynchronous trading effect:    Lo and MacKinlay (1988) and Conrad and Kaul (1988) find that weekly returns on portfolios by size show reliable positive autocorrelation, which is stronger for small stocks. However, this autocorrelation may largely due to nonsynchronous trading effect (Fisher 1966), therefore, is spurious.

4)      Time-variation of expected return:    Fama and French(1988) and Poterba and Summers (1988) find the negative autocorrelation of returns in long horizon as predicted by Shiller-Summers mean-reversion model ( Shiller (1984) and Summers (1986)). But the autocorrelations in price swings can be mainly explained by the rational time-varying expected returns (Fama-French (1989)).

5)      Data-dredging problem:  one example is that monthly returns of diversified portfolios demonstrate greater correlation than those of individual stocks do( Fisher's (1966)).

(2)  Assuming CAPM, and auto correlation, is it a violation or not? if it is not, why? If it is, how can investors get the abnormal return.

Assuming that CAPM is the true model and the detected auto correlations are true too, there could be a violation of the market efficiency.  Investors may use ‘contrarian’ or ‘momentum’ strategy to get the abnormal return.

Following ‘contrarian strategy’( DeBondt and Thaler (1985)), to exploit the negative serial correlation, an investor buys ‘loser’ stocks and sell them after 3to 5 years when these stocks demonstrate strong performance.

Following ‘momentum strategy’ (Jegadeesh and Titman(1993)), an investor may buy the ‘winners’ based on the performance in the past 6-month and sell them after 6-month holding period. During 1965-1989 period, this method could generate an excess return of 12.01% per year on average.

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