Ipo,book Building,underpricing

Question A: The IPO process is characterized by information asymmetries. Explain how these asymmetries may be reduced through the book-building process.

IPO Process:

In the initial public offering (IPO) process, three parties, the issuing firm, the underwriters and IPO Investors are involved to make this process more effective. Michael et al (1994), found that in the process of issuing IPO, reputation of underwriter also count a lot and reputable underwriter perform better than average. In the initial public offering process, the underwriter is responsible to facilitate both firm and investors by providing equal, accurate and timely information that lead to accurate decisions taken by firm and investors regarding their best interest. But due to complexity of IPO process, information asymmetric phenomena arises that would be reduced through book building process.

How Book building reduces information asymmetry:

Book building is basically a process of determining the price of initial public offering before issuing into the capital market. Wolfgang et al (2003), found that with the help of book building process underwriter would be able to collect positive information from potential IPO investors. In this process, underwriters have a key responsibility to suggest to potential investors that the purchase of the IPO is a healthy investment. In order to reduce asymmetric information, underwriter should have to understand the issuing company. That's why the underwriters are likely to spend large amount of time performing business, making prospectus and due diligence that are consistent with the information provided.

Ritter and Welch (2002), pointed out that there are two kinds of information asymmetries exist between IPO issuer and investors.

1. Issuing firms are more informed about their own business situation than investors.

2. Investors are more informed about factors outside firm than issuers, for example superior information about competitors.

Vernimmen (2009), pointed out that in book building process, first underwriter analyze the internal information of issuing firm, after that guarantee is given by the underwriter to issuing firm that partly resolve the problem of asymmetric information. Research notes, warm-up presentation and road shows with institutional buyers are the source of reducing information asymmetry. Sherman (2000), state that in order to reduce information asymmetry underwriter should make a long term relationship with IPO investors. After knowing the demand and price of IPO, final prospectus is delivered by issuing firm to the IPO investors that would also helpful to resolve the problem of information asymmetry. Vernimmen (2009), state that the allocation of shares to potential investors depends upon the consent of issuing company and reducing information asymmetry. Book building process helps the underwriter to know about the view point of investors regarding the price and the demand of IPOs. By having that kind of information regarding investors view point, the underwriter would be able to determine the accurate price and the size of the initial public offering that would also lead towards reducing information asymmetry. Thus on the basis of resolving the problem of asymmetric information, we can say that book building process of discovering the price of initial public offering is better than the process of fixed pricing

Question B: Researchers have noticed that IPO's tend to be underpriced in the short-term and to under-perform in the long-term. Explain how under-pricing is measured in empirical studies and explain why these phenomena of under pricing in the short-term and under-performing in the long-term are observed.

IPO Under pricing:

The process of selling IPO lower than the initial market price is known as IPO under pricing.

An average, IPO is under priced. Jenkins et al (2004), pointed out that by obtaining positive information from the potential investors, underwriter make a commitment with the informed investors regarding the price of IPO. Empirical studies shows that the main reason of IPO under pricing is asymmetric information, Rock (1986) state that there are two groups of IPO investors, one is informed and the other is uninformed. Thus to reduce asymmetric information effect, companies under priced their shares to attract uninformed investors. Ritter (1991) pointed that the process of under pricing looks to be short run