An examination of underpricing and short-Term aftermarket volatility in New Zealand initial public offerings

Abstract

In a well functioning market, price is the best estimate of the present value of the cash flows expected to accrue to a security. In such a market the expected (risk adjusted) residual from a diversified portfolio of securities is zero. This thesis examines whether the New Zealand Initial public Offering (IPO) market functioned well by examining underpricing and the volatility of aftermarket residuals. Underpricing continues since Ibbotson's (1975) rigorous analysis. While Ibbotson perceived underpricing as a "puzzle" some theoretical models see it as a signal of issue quality. The approach adopted in Ritter (1987), to examine underpricing from the perspective of a financial manager rather than from the standpoint of an investor is adopted here. Choices made by the vendor of the securities (e.g., as to the organising broker, or how much of the voting capital to retain post-issue) influence the amount of underpricing available to investors. Without investors the IPO cannot achieve its dual objectives of providing new equity and enabling existing shareholders to avert risk. Mean (median) underpricing in the data set is 32.04% (15.98%). Vendor choices correlated with underpricing include the mechanisms used to market the securities, the level of retention by existing shareholders, and the reputation of the organising broker. Multivariate analysis indicates that variables discerned from the offer documentation explain approximately 15% of underpricing. The analysis indicates the percentage of the firm retained by the existing shareholders post-issue is the most reliable signal of underpricing. The second portion of the thesis, a focus on the volatility of short-term aftermarket residuals, is designed to extend Ritter (1991). Mean (median) risk adjusted residual for the 30 trading days after listing is -4.76% (-7.59%). The standard deviation of the 30-day residual is 24.40%, lower than that reported in McGuinness (1993). Mean (median) volatility of the daily residuals is 4.91% (3.93%)with a standard deviation of 3.66%. Evidence is presented of differences in the volatility of daily aftermarket residuals on some partitions (e.g., choice of an offer mechanism, management's familiarity with the assets, and how the IPO securities are marketed). The multivariate analysis highlights management's familiarity with the post-IPO assets as the key determinant of aftermarket volatility, which is consistent with the variable being a proxy for differing levels of risk.