Underpricing of initial public offerings in Indian capital market

Abstract

This paper is an attempt to empirically explore the determinants of underpricing of Initial Public Offerings (IPOs) in the Indian Capital Market. IPOs are one of the largest sources of capital for the firms to invest in the growth opportunities. It encourages investment activities in the economy by mobilizing funds from low growth opportunities to high growth opportunities. It has been observed that IPOs are underpriced in most of the countries (Loughran, Ritter and Rydqvist 1994). Underpricing is the pricing of the issue at lesser price than the true value of the issue. The degree of underpricing varies from country to country and issue to issue in the same country. The underpriced IPO leaves money on the table which is a cost (loss of capital) for the company and the same becomes a gain for the investors in the form of positive initial returns on the underpriced shares. Though underpricing is a cost for the issuing company, the issuing company underprices the issue. There are many theoretical explanations for underpricing of IPOs. This is an empirical study which aims to find out the factors which are causing underpricing in India. The underpricing of IPOs is a serious problem for any economy. On the one hand, high underpricing tendency in the primary market discourages IPOs issued by those companies which cannot afford or do not want underpricing (leaving money on the table). On the other hand, it creates arbitrage activities in the secondary market and in the grey market. The underpricing of IPOs thus hampers the growth opportunities and creates instability in the secondary market. In India, introduction of book building mechanism of IPOs in 1998 aimed to reduce underpricing because in the book building mechanism, offer price of the issue is determined on the basis of market feedback. The present study on 227 book-built IPOs for the period of 2004 to 2009 found that the average underpricing during this period was 28 per cent while the maximum underpricing was around 242 per cent. Thus underpricing of IPOs is still an issue of concern.