Why New Issues are Underpriced

The essay proposes a model for assessing the under-pricing of initial public offerings, and takes an alternative approach to current assumptions about pricing. The model is set in the new issues market, especially the market for firm commitment offerings. The model is tested to assess the degree to which shares are rationed on the offer date. The assumption is that, if the model is correct, the careful calculation of the returns by the probabilities of getting an allocation should make the uninformed investor earn a rate without risk. The analysis subsequently demonstrates that the equilibrium offer price includes a finite discount in order to attract uninformed investors. It is argued that, if new shares are priced at expected values, a handful of privileged investors eliminate the others when good issues are offered, and they withdraw from the market when the issues are less advantageous. The findings also show that the optimal offer price is part of a continuum of feasible prices. Concludes with ways in which this model for firm commitment offerings could be generalized. (CBS)