Initial Public Offering (IPO) has lots of unique characteristics which including short-term underpricing, price stabilization, and investment banks. IPOs are always underpriced which means the pricing of IPOs often below its market value. This is because of concerns relating to liquidity and uncertainty about the level at which stock will trade.
The lesser the liquid and uncertainty about the shares are, the more underpriced they will have to be in order to compensate investors for the risk they are taking.An IPO’s issuer tends to know the value of the shares than the investor so a company has to underpriced its stock to encourage investors to invest the IPO. Companies that want to venture out and start selling their shares to public have find a way to stabilize their initial share prices. One of the ways to stabilize the initial share prices is through a legal mechanism which greenshoe option. A greenshoe option is a clause that contain in the agreement of an IPO which allows the underwriters to buy up to additional 15% of company shares at the offering price.
Normally the underwriter works as a liaison (like a dealer) and finding buyers to buy their shares that their client is offering. The price of the shares is determined by the sellers and the buyers. After the prices has determined, the shares are ready to sell to the public. The underwriter has to ensure that the shares do not below the offering price. Once the underwriter found there is chances of the shares trading below its offering price, they can exercise the greeshoe option. Other factors for IPO are ranking of investment banks.
Prestigious underwrites just tend to market the high-quality firms. An research finds that there is a negative relationship between the level of prestige and the magnitude of underpricing by Carter and Manaster (1990). Investment bank ranks the IPO due to the market share on basic average deal size and number of IPOs underwritten. Reputable investment banks resolve a greater uncertainty of IPO, because those reputable underwriters are associated with more active filling price and less secondary market return variability.