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What makes issuers happy? Testing the Prospect Theory of IPO Underpricing

Authors: Ljungqvist, Alexander P.
Wilhelm, William J.Jr.
Keywords: Prospect theory;Behavioral finance;Initial public offerings;Underpricing
Issue Date: 10-Dec-2003
Series/Report no.: FIN-03-038
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) prospect theory of 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.
Appears in Collections:Finance Working Papers

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