Allocations, Adverse Selection and Cascades in IPOs: Evidence from Israel

Abstract

This paper examines three theories of IPO underpricing, using data from Israel where the allocations to subscribers are equally prorated and publicly known. Rock’s (1986) theory of adverse selection is supported: subscribers receive greater allocations in overpriced IPOs. And, while the average IPO excess return is 12%, the simulated allocation-weighted return to uninformed investors is slightly negative. Welch’s (1992) theory of information cascades is supported by the pattern of allocations: demand is either extremely high or there is undersubscription, with very few cases in between. Also supported is the proposition that underpricing is a means to increase ownership dispersion.