CHAPTER TWO

A REVIEW OF THE LITERATURE ON THE PRICE

PERFORMANCE OF IPOs

2.0 INTRODUCTION

The objective of this chapter is to survey two empirical regularities for the

initial public offerings (IPOs): (1) short-run underpricing, and (2) long-run

overpricing. The short-run underpricing refers to the pattern of positive average

initial returns. This initial return is defined as the percentage price change from the

offering price to the closing price on the first day of trading. While the long-run

overpricing refers to the pattern of lower returns on IPOs than for comparable firms

for several periods following the offer.

In carrying out the literature survey, two sections of analysis are considered. First, a

survey of prior studies examining the degree and determinants of the level of

underpricing in initial public offerings is provided in section 2.1. In constructing this

section, we investigate the levels of underpricing, measurement methods and time

intervals reported in prior studies. Then, explanations of initial performance reported

are discussed.

Following this, the literature relevant to the aftermarket performance in IPOs is

analysed. In this analysis we conduct a review of prior studies, covering a range of

IPOs across markets, time periods and sample sizes. Finally, explanations of the

aftermarket performance of IPOs are made.

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 2.1 A SURVEY OF INITIAL RETURNS

2.1.1 LEVELS, MEASURING AND TIME INTERVALS OF INITIAL RETURNS

2.1.1.1 Levels of Initial Returns Reported in Prior Studies

In this section, a wide range of underpricing levels is reported. For instance,

for the U.S., table 2.1 illustrates average initial returns from 3.17 % in Ng and Smith

(1996) to levels of 48.4 % are recorded in Ritter (1984). However, table 2.2 shows a

better consistency in initial returns levels for the UK. This observation may be due,

in part, to the limited number of studies available for analysis in the UK. Later in this

chapter, we clarify that the UK evidence sheds light on a number of issues left

unresolved by the U.S. studies.

Table 2.3 illustrates limited evidence for Australia; Canada; Finland; France;

Germany; Japan; Netherlands; and Switzerland, indicating initial returns from the

underpricing of IPOs similar to those reported for securities in the U.S. and UK. In

addition, table 2.4 shows evidence of underpricing for unseasoned stock securities

for newly industrialised and developing countries (i.e., Hong Kong, Malaysia,

Singapore, Thailand, Brazil, Chile, and Mexico). Likewise, in table 2.4 the findings

are consistent with U.S. and UK patterns of positive initial returns. Having known

the levels of underpricing, it can be noted that IPOs produce meaningful positive

returns in early trading for those investors beneficial enough to be allocated shares in

such securities. In that case, for the purpose of this thesis, it is important to analyze

the measurement methods of this initial returns. Thus, the following section outlines

such methods.

21
Table 2-1 Summary Review of Levels of Returns in the U.S.A Market of IPOs

Author(s) Year No. of Study Average Initial

IPOs Period Return (%)
Reilly and Hatfield 1969 53 1963-65 9.6
Bear and Curley 1970 140 1969 12.9
Stoll and Curley 1970 205 1957-63 42.4
McDonald and Fisher 1972 142 1969 28.5
Logue 1973 250 1965-69 41.7
Reilly 1973 53 1963-65 9.6
Reilly 1973 62 1966 9.9
Neuberger and Hammond 1974 816 1965-69 17.0
Ibbotson 1975 112 1960-69 12.8
Ibbotson and Jaffe 1975 128 1960-70 16.8
Reilly 1977 486 1972-75 10.9
Block and Stanley 1980 102 1974-78 6.0
Neuberger and LacChapelle 1983 118 1975-80 27.7
Ritter (a) 1984 1028 1977-82 26.5
Ritter (b) 1984 325 1980-81 48.4
Beatty and Ritter 1986 545 1981-82 14.1
Chalk and Peavy 1987 649 1975-82 21.7
Miller and Reilly 1987 510 1982-83 9.9
Balvers et al., 1988 1182 1981-85 7.8
Tinic 1988 134 1966-71 11.1
Johanson and Miller 1988 962 1981-83 10.5
Beatty 1989 2215 1975-84 22.1
Muscarella and Vetsuypens 1989 38 1970-87 7.1
Jenkinson 1990 1322 1985-88 10.4
Aggarwal and Rivoli 1990 1598 1977-87 10.7
Carter and Manaster 1990 501 1979-83 16.18
Ritter 1991 1522 1975-84 14.3
Barry et al., 1991 723 1983-87 7.38
Drake and Vetsuypens 1993 93 1969-90 9.18
Barry and Jennings 1993 229 1988-90 6.78
Hanley et al., 1993 1523 1982-87 9.61
Garfinkel 1993 549 1980-83 10.2
Slovin et al., 1994 175 1973-88 12.1
Clarkson 1994 420 1976-85 13.93
Schultz and Zaman 1994 72 1992 3.9
Alli et al., 1994 185 1983-87 5.28
Dunbar 1995 480 1980-83 16.8
Ng and Smith 1996 1991 1981-88 3.17*
Ng and Smith 1996 1991 1981-88 0.7*
* 3.17 % with warrant compensation 0.7 without warrant compensation.

22
Table 2-2 Summary Review of Levels of Returns in the UK Market of IPOs
Author(s) Year No. of Study Average Initial
IPOs Period Return (%)
Merritt, et al., 1967 149 1959-63 13.7
Davis and Yeomans 1976 275 1965-71 10.6
Buckland et al., 1981 297 1965-75 9.7
Jenkinson and Mayer 1988 20 1979-87 22.2
Jenkinson 1990 197 1985-88 12.2
Levis 1990 123 1985-88 8.6
Levis 1993 712 1980-88 14.3
Menyah et al., 1995 40 1981-91 23.6*
* privatisation sales.

Table 2-3 Summary Review of Levels of Returns in Other Developed Markets of IPOs
Market: Author(s) Year No. of Study Average Initial
IPOs Period Return (%)
Australia Finn and Higham 1988 93 1966-78 29.2
Australia Lee et al., 1996 266 1976-89 11.86
Canada Jog and Riding 1987 100 1971-83 11.0
Canada Cheung and Krinsky 1994 N/A 1982-88 6.8
Finland Keloharju 1993 79 1984-89 8.6
France McDonald and Jacquillat 1974 31 1968-71 3.0
France Jacquillat et al., 1978 60 1966-74 5.2
France Jenkinson and Mayer 1988 11 1986-87 25.1
France Husson and Jacquillat 1990 131 1983-86 4.0
Germany Uhlir 1989 97 1977-87 25.1
Japan Dawson and Hiraki 1985 106 1979-84 51.9
Japan Jenkinson 1990 22 1986-88 19.7
Japan Kunimura and Severn 1990 551 1969-80 1.42
Netherlands Wessels 1989 46 1982-87 5.1
Switzerland Kunz and Aggarwal 1993 42 1983-89 35.8
N/A = not available.

Table 2-4 Summary Review of Levels of Returns in Newly industrialised and Developing Countries
Market: Author(s) Year No. of Study Average Initial
IPOs Period Return (%)
Hong Kong Dawson and Hiraki 1985 31 1979-84 10.9
Hong Kong Dawson 1987 21 1978-83 13.8
Korea Kim and Lee 1990 41 1984-86 37.0
Korea Krinsky et al., 1992 275 1985-90 79.0
Malaysia Dawson 1987 21 1978-83 166.6
Singapore Wong and Chiang 1986 48 1975-84 56.0
Singapore Dawson 1987 39 1978-83 38.4
Singapore Koh and Walter 1989 70 1973-87 27.0
Thailand Wethyavivorn and Koo-Smith 1991 32 1988-89 68.69
Latin American Countries
Brazil Aggarwal et al., 1993 62 1980-90 78.5
Mexico Aggarwal et al., 1993 44 1987-90 2.8
Chile Aggarwal et al., 1993 21 1982-90 16.3 **
Chile Aggarwal et al., 1993 36 1982-90 7.6**
** 16.3 % (full sample) and 7.6 % (privatisation sample = 21).. a 6th month.

23
2.1.1.2 Measurement Methods of Initial Returns Reported in Prior Studies

Essentially, two methods are found to be employed in the measurement of

initial performance of IPOs, namely:

1. Market-Adjusted Returns Model, and

2. Risk-Adjusted Returns Method.

First, a large number of studies, such as Finn and Higham (1988), Ritter

(1991), Kelokarju (1993), Levis (1993), Aggarwal; Leal and Hernandez (1993), and

Lee; Taylor and Walter (1996), employed the market-adjusted returns measure,

ARit = Rit - Rmt

where ARit is the market-adjusted excess return of stock i in period t, Rit is the raw

return of stock i in period t, and Rmt is the market portfolio return in the same time

period. That is, the returns are adjusted to the market returns over the same time

period. In analysing this model, some features can be clarified as follows:

 It calculates the ex post abnormal return on any security as the difference

between its return and that on the market portfolio.

 It assumes that ex ante expected returns are equal across securities for a particular

time interval, but not necessarily constant overtime.

 It takes into account market-wide movements that occur at the time of the event

being studied.

 It assumes that the systematic risk of each security in the sample is one. That is

true only if we believe that systematic risk is rewarded.

24
 The last feature of this model implies the lack of the introduction of risk

measurement in the analysis. Alternatively, some studies thus employ the risk-

adjusted returns method in measuring the price performance of the IPOs. In the latter,

the sensitivity of the introduction of risk in analysing returns of the IPOs is

examined.

In the risk-adjusted method, the mean excess returns could be measured using
1
the RATS model. This model was originally developed by Ibbotson (1975), then by

Warner (1977), and finally by Clarkson and Thompson (1990) and employed by

Keloharju (1993) and others, as a proposed cross-sectional estimation technique for a

portfolio of securities separated in time.

The RATS model was first formulated by Ibbotson (1975) based on the two-

parameter model of the CAPM of Sharpe (1964) and Lintner (1965). The latter was

derived as the equilibrium implications of investors using a mean-variance approach

to portfolio construction. The two-parameter model is expressed algebraically in the

first equation of the work of Ibbotson (1975) as:

~ ~ ~ ~
E ( R j )  E ( 0 )  [ E ( Rm )  E ( 0 )]  j (1)

Where,
~
E(R j ) is the expected return on any asset j;
~
E(Rm) is the expected return on the market portfolio;
~
E( 0) is interpreted as the expected return on any security whose return is
~
uncorrelated with Rm ; and
~ ~
Cov(R j , Rm)
j  ~
,
 (Rm)
2

1 Since Ibbotson combined returns across time and securities, the model is designated as RATS.

25
 ~
Ibbotson (1975) assumes that a linear relationship exists between asset returns R j ,

~ ~
 0 and Rm , and he restated eq. (1) as:
~ ~ ~ ~
R j   j   j ,0  0   j ,m Rm  e j , (2)

where
~ ~
Cov(R j , Rm)
 j,m  ~
  j,
 (Rm)
2

~ ~
Cov( 0 , Rm)
 j,0  ~
 1   j , and
 (Rm)
2

~
e j is the stochastic disturbance term for asset j.

Rearranging eq. (2) into excess return form and making use of period-by-

period returns by adding the subscript t, Ibbotson obtained

~ ~ ~ ~ ~
( R j ,t   0 ,t )   j   j ( R m ,t   0 ,t )  e j ,t . (3)

and he formulated the conditional expectation of eq. (3) as

~ ~ ~ ~
E (R j,t   0,t | R m,t   0,t )  j   j (R m,t   0,t ).

According to Ibbotson (1975):-

 The market equilibrium model described by eq. (1) says that  j  0 for all j.

 Estimates of  j in eq. (3) provide measures of 'abnormal performance' of new

securities.

Hence, the two-factor model was used by Ibbotson to model returns across

time and securities (RATS). That is, he formulated the following RATS regression

model for general class of one-stock portfolio regressions:

~ ~ ~ ~ ~ ~ ~
( R j ,n   0 )  n  n,0 ( R m   0 )  n , 1 ( R m, 1   0, 1 )  E j ,n (4)

26
where

n is the month of seasoning, which is held constant in each regression;

~
R j ,n is the return of security j during the nth month of seasoning;

n is the regression constant that is the average return in excess of the returns
implied by the equilibrium relationship described in eq.(1)
(  n will serve as a measure of abnormal performance);
 n,0 is the regression coefficient for the unlagged independent variable;

 n,1 is the regression coefficient for the independent variable lagged one month;
~ ~ ~
R m, 0 are measured during the same calendar month as R j,n for the unlagged
~ ~
independent variable ( (R m   0) , and measured in the previous calendar
~ ~
month for the lagged independent variable (R m,1   0,1) ;
~
E j ,n is the stochastic disturbance term for asset j during the nth month of
seasoning.
In analysing the RATS model defined in eq. 4, some features can be shown as

follows:

 It assumes that the addition of the lagged independent variable is useful in

reflecting part of a stock's actual return for any month in the next month's

measured return2.

 It assumes that the addition of the lagged independent variable does not affect the

statistical properties of the model and may reduce the residual variation.

 It assumes that multicollinearity is difficult to be found since returns from the

market portfolio are independent from month to month.

2 Ibbotson examined the lack of timeliness of quotes by running the RATS regression model of eq. (4) including various lag
terms in the independent variable. His preliminary results indicated that only the first lag is important.

27
 The true beta, bn , is assumed to be approximately equal to the sum of the lagged

and unlagged betas, bn  n,0  n,1 .

 It has a particular advantage of allowing for the contingency that the systematic

risk of new securities may change as the securities become seasoned.

 It is not a direct transformation of the two-parameter model described in eq. (3).

~ ~
 Unlike the R j,t in eq. (3), the R j,n in eq. (4) are drawn from distributions

exhibiting differing systematic and unsystematic risks because a different

security j is in the portfolio each month. Thus, the true  n in eq. (4) is not fixed

but has a different value,  j , for each asset j.

Despite these benefits of examining time independence securities in the

RATS approach, Ibbotson (1975) notes that the significance of initial returns, and the

broad findings for aftermarket efficiency, would probably be revealed by less

complex risk-adjusted approaches. This view is also apparent in Jacquillat,

McDonald and Rolfo (1978), and Finn and Higham (1988), where RATS approaches

to the measurement of aftermarket returns in France and Australia respectively are

found.

2.1.1.3 Time Intervals Reported in Prior Studies

For the time intervals of calculating excess returns, the survey revealed that a

number of different time intervals were used. The calculation was performed over the

period between the initial offering day and the close of trading on the first day of

listing, such as:

 Levis (1990), Levis (1993), and Menyah et al., (1995) in the analysis of UK

offerings;

28
 Stoll and Curley (1970), McDonald and Fisher (1972), Chalk and Peavy (1987),

Miller and Reilly, and Muscarella and Vetsuypens (1989), Drake and Vetsuypens

(1993), Garfinkel (1993), Hanley et al., (1993), Alli et al., (1994), Clarkson

(1994), Slovin et al., (1994), Schultz and Zaman (1994), Dunbar (1995) and Ng

and Smith (1996) for U.S. offerings;

 McDonald and Jacquillat (1974) for France securities; Jog and Riding (1987),

and Cheung and Krinsky (1994) for Canadian securities; Finn and Higham

(1988), and Lee et al., (1996) for Australian securities;

 Wong and Chiang (1986) and Dawson (1987) for Pacific Basin offerings; and

 Aggarwal et al., (1993) for Latin American offerings.

Also, excess returns was measured over the period between the initial

offering day and the close of trading at the end of the first week of listing, [see e.g.,

Neuberger and LaChapelle (1983) and Tinic (1988) for the U.S., and Cheung and

Krinsky (1994) for Canadian securities]. Moreover, excess market returns were

measured over the period between the initial offering of shares and the closing

trading date one month after listing [see Logue (1973) and Ibbotson and Jaffe (1975)

for the U.S.; and Kunimura and Severn (1990) for Japanese offerings].

29