The effects of moral hazard and adverse selection on the pricing and underpricing of initial public offerings

Abstract

Underpricing research to date relies on the assumption that there exist a negative relationship between the pricing of an initial public offering (IPO) and its first day returns. Consequently, little is known in the literature on IPOs as to which part of initial returns is due to ‘deliberate underpricing’ (that is, a discount on the ‘true’ value of the offer) and which part is due to market reaction on the first trading day. In this paper we theoretically untangle this assumed relationship between offer pricing and first day gains. Consistent with the proposed model, our results show that different antecedents affect the two outcomes and that their relationship is positive. Our model and findings provide interesting implications for research, public policy and practice.