Does Prospect Theory Explain IPO Market Behavior?

Abstract

We derive a behavioral measure of the IPO decision-maker’s satisfaction with the underwriter’s performance based on Loughran and Ritter’s (2002) application of prospect theory to IPO underpricing. We assess the plausibility of this measure by studying its power to explain the decision-maker’s subsequent choices. Controlling for other known factors, IPO firms are less likely to switch underwriters for their first seasoned equity offering when our behavioral measure indicates they were satisfied with the IPO underwriter’s performance. Underwriters also appear to benefit from behavioral biases in the sense that they extract higher fees for subsequent transactions involving satisfied decision-makers. Although our tests suggest there is explanatory power in the behavioral model, they do not speak directly to whether deviations from expected utility maximization determine patterns in IPO initial returns.