Signalling and the Pricing of Unseasoned New Issues

This paper develops a signalling model with two signals, two attributes, and a continuum of signal levels and attribute-types to explain a puzzling phenomenon: the underpricing of new issues. Both the fraction of the new issue retained by the issuer and its offering price convey the unobservable "intrinsic" value of the firm and the variance of its cash flows to investors. Many of the model’s comparative statics results are quite novel, empirically testable, and consistent with the existing empirical evidence on new issues, as well as the beliefs of many investment professionals. In particular, a closed-form solution for the signalling schedule indicates that the degree of underpricing, which can be inferred from observable variables, is positively related to the firm's post-issue share price.