Overpricing (and underpricing) in IPOs : a model of excess initial returns

Abstract

This paper develops a model in which new issues, in equilibrium, may be overpriced or underpriced, depending on parameter values. The ability of an investor to withdraw from the offering upon observing unfavorable information implies that the decision to participate in it contains a valuable option. It is shown that the presence of this option will generate overpricing in equilibrium to the extent that the option value exceeds the corresponding adverse selection cost. The empirical implications of the model are closely consistent with the pattern of overpricing and underpricing revealed by the data.