IPO Underpricing: A Liquidity Based Explanation

Abstract

The underpricing of initial public offerings (IPOs) is a deeply investigated phenomenon, commonly explained with asymmetric information and risk. Ellul and Pagano (2006) first linked the underpricing with liquidity proxies like liquidity risk and effective spread. In this paper I propose a different liquidity based framework which compares an IPO to a large sell-initiated block trade, and the underpricing to the price pressure effect of the trade itself, which means the price for the liquidity “bought” by the seller. As a result, we should expect this price to be lower (higher) for more (il)liquid stocks. The framework is supported by empirical results for a sample of Italian IPOs, where underpricing is negatively related with several liquidity measures after controlling for the oversubscription level and other usual explanatory variables in IPO studies.

Keywords: initial public offerings, underpricing, liquidity, oversubscription

JEL Classification: G12, G14, G24