IPO First-Day Return and Ex Ante Equity Premium

Abstract

This paper proposes a new measure of ex ante equity premium, IPOFDR, which is the average difference between the offer price and the first-trading-day close price of IPO shares. The relation reflects the stylized fact that IPO issuers only partially incorporate market information during bookbuilding. I test the idea in three ways using U.S. data over the 1960 to 2006 period. First, there is a positive relation between IPOFDR and future market returns, and the relation is statistically significant in both in-sample and out-of-sample tests. Second, the unanticipated change in IPOFDR performs just as well as HML in explaining the cross-section of stock returns. Third, IPOFDR forecasts stock returns mainly because of its relation with stock market variance and average idiosyncratic variance, which are arguably measures of stock market risk.

Keywords: IPO, Equity Premium, Stock Return Predictability, Risk-Return Relation

JEL Classification: G1