Do the underwriters efficiently set first-trade prices in IPOs?

Abstract

While there is extensive literature documenting the discrepancy between IPO offer prices and their respective closing prices on the first day, few had examined the relationship between the offer, first-trade, and the first-day closing prices of IPOs. We examine the IPO trading return on the first day (opening price-to-closing price) to determine whether investment banks are efficient in setting the first-trade prices. We also examine when final offer price is set relative to when trading starts as a proxy for level of oversubscription. We find that open-to-close return is positive and significant. It is negatively related to the offer-to-open return, even after controlling for issue characteristics and market conditions. This is particularly prominent during the bubble period when laddering agreements were arguably widespread. These findings suggest the possibility of substitution between lower offer-to-open return for higher open-to-close return in the secondary market. We also find that high ranked underwriters are more conservative in setting of the first-trade price relative to the closing price in first-day trading. They tend to leave more return to the secondary market investors even after controlling for our measures of difficulty in setting the offer price. Overall, these results suggest that information learned in the book-building process is important in explaining the first trading day returns.