The Winner's Curse Problem, Interest Costs and the Underpricing of Initial Public Offerings

Abstract

This paper provides the first direct test of the winner's curse problem proposed by K. Rock (1986) as an explanation to the underpricing of initial public offerings. Moreover, it tests the proposition that the underpricing of initial public offerings in the United Kingdom is due to the combined effect of the winner's curse problem and the particular nature of the settlement mechanism applicable in the British new issues market. The evidence demonstrates that when these two factors--winner's curse problems and interest rate costs--are taken into consideration, the emerging first day net returns are, on average, markedly lower than the level of actual underpricing. Consistently, superior performance can only be achieved by predicting the market's response to the individual new issue. The results, however, indicate that such predictive ability is largely unattainable. Copyright 1990 by Royal Economic Society.