Underpricing of Initial Public Offerings in the Indian Capital Market

Abstract

This paper investigates the reasons behind the underpricing of initial public offerings (IPOs) in the Indian Capital Market. Initial Public Offerings are the one of the largest source of capital for the firms to invest in the growth opportunities. It encourages investment activities in the economy by mobilizing funds from the low growth opportunities to the high growth opportunities. It has been observed that Initial Public Offerings are underpriced in most of the countries (Loughran, Ritter and Rydqvist 1994).Underpricing is the pricing of the issue at lesser price than the true value of the issue. The degree of underpricing varies from country to country and issue to issue in the same country. The underpriced Initial Public Offering leaves money on the table which is cost for the company and the same becomes a gain for the investors in the form of positive initial returns on the underpriced shares. Though underpricing is a cost for the issuing company, the issuing company underprices the issue. There are many theoretical explanations for underpricing of initial public offerings. This is an empirical study which aims to find out the reasons which are causing the underpricing in the Indian Capital Market. The underpricing of initial public offerings is a serious problem for any economy. As on the one side high underpricing tendency in the primary market discourages initial public offerings by those companies which cannot afford or do not want underpricing or leaving the money on the table. On the other hand it creates arbitrage activities in the secondary market and in the grey market. The underpricing of initial public offerings thus hampers the growth opportunities and creates instability in the secondary market.In the Indian Capital Market introduction of book building mechanism of initial public offerings in 1998 aimed to reduce the underpricing. As in the book building mechanism the offer price of the issue is determined on the basis of market feedback .The present study on 227 bookbuilt IPOs for the period of 2004 to 2009 found that the average underpricing during this period was 28 percent while the maximum underpricing was around 242 percent. Thus underpricing of IPOs is still a issue of concern. Section 1 of the paper contains introduction, section 2 an overview of the regulatory system of initial public offerings in India, section 3 the review of literature on the subject, section 4 a description of sample and data set used in this study, section 5 the model and empirical results of the model and section 6 summarizes the findings.