Demand uncertainty, Bayesian update, and IPO pricing

Abstract

When the market undergoes a learning process about the IPO, it takes time for the demand to reach the equilibrium consistent with the new issue’s intrinsic value. Hence, the temporary short-term demand can deviate substantially from the stabilized long-term demand. This difference requires the underwriter to respond differently to different pre-market conditions that are dictated by the short-term demand: While she must accommodate the overly pessimistic views of investors in a cold IPO (because the shares cannot be sold at a perceived premium), she has the option to respond only partially to investors’ overly optimistic views in a hot IPO. We model this asymmetric response of the underwriter and derive IPO regularities relating underpricing, partial price revision, and long-run underperformance. We provide evidence that supports the model’s predictions.