Divergent Opinions in the Pre-Issue Market and the Pricing of Initial Public Offerings

Abstract

Investors in an initial public offering (IPO) face a lack-of-information problem: They have to guess the new stock’s aftermarket price. This problem poses a risk when there is no consensus in investors’ pre-issue opinions and the risk is greater when the opinions are more divergent. We model this lack-of-information problem in an IPO, where, to place a certain number of the shares, the issuer adjusts the offer price to accommodate the difference in demand between the pre-issue market and the aftermarket. By examining a large sample of IPOs, we obtain evidence in strong support of the model’s predictions for IPO underpricing and sales.