Economic theory behind Initial Public Offering (IPO) underpricing : an evaluation of the pricing mechanisms which influence the economic forces leading to this puzzling occurrence

Abstract

One of the big puzzles in finance is the systematic underpricing of shares being sold in an Initial public offering (IPO). The primary objective of this paper is to utilise economic theory to understand what leads to this puzzling underpricing phenomenon and to propose a more efficient pricing mechanism. By unfolding the workings of economic theory a deep understanding of the factors driving this mechanism is achieved. This understanding is then used to evaluate the impact each IPO pricing mechanism has on this phenomenon. Thus revealing a pricing mechanism which could be used to mitigate or eliminate this inefficiency. The utilisation of the more efficient pricing method results in firms obtaining a price which reflects more closely the true value of their shares, resulting in Pareto improvements where funds would be put to better use. The methodology used involves a critical evaluation of existing theory as well as additional insights into other economic theory which improve on existing explanations. This is followed by a thorough evaluation of pricing mechanisms available; and leads on to the recommendation of the ideal pricing method. It is concluded that Auctions appear to be the most efficient of pricing methods. Auctions tend to mitigate most of the economic forces which instigate the underpricing phenomenon. In practice, however, auctions are seldom used. The major reasons behind this under-utilisation are outlined. finally, it is recommended that, a variant of auctions known as 'Dirty auctions' should be used in IPOs. This combination of microeconomics, financial economics and behavioral economics contributes to facilitating and promoting a more efficient initial public offering market.