Comments on the Signaling Theory of IPO Underpricing and Investor Protection Laws

Jeong-Yoo Kim

Asian Journal of Law and Economics, 2024, vol. 15, issue 1, 151-165

Abstract: It has been widely known that good firms use lower IPO prices to signal their superior prospects to investors. The underlying intuition is that good-type firms signal their type by underpricing their initial issue of shares, because investors can rationally infer that only the best can recoup the signaling cost from subsequent issues. In this paper, we argue that the intuition is not complete. We show that a good firm always has an incentive to deviate to raise the IPO price slightly from its equilibrium price if the price is the only signaling device, implying that signaling by underpricing is not an equilibrium phenomenon in the case of one-dimensional signal. Then, we show that if the firm can choose the equity fraction to be sold as well, a good-type firm can signal its high profitability by choosing a low equity fraction. In this case, a good-type firm engages in underpricing, but it cannot be a signal because both types choose same prices in equilibrium. We also discuss the effect of investor protection laws on IPO underpricing.

Keywords: investor protection laws; IPO; IPO puzzle; separating equilibrium; signaling; underpricing (search for similar items in EconPapers)
JEL-codes: G10 G12 G30 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1515/ajle-2023-0153

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