Optimal Exercise of the Over-Allotment Option in IPOs

Muscarella, Chris J.; Peavy, John W.; Vetsuypens, Michael R.

doi:10.2469/faj.v48.n3.76

Cited by 19 publications

(10 citation statements)

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“…Hanley (1993) reports that 66 percent of firm commitment IPOs in 1983 to 1987 exercise overallotment options. Muscarella Peavy and Vetsuypens (1992) report similar numbers.…”

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confidence: 63%

The New Issues Puzzle

Loughran¹,

Ritter²

1995

The Journal of Finance

2,510

723

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Companies issuing stock during 1970 to 1990, whether an initial public offer ng or a seasoned equity offering, have been poor long-run investments for investors. During the five years after the issue, investors have received average returns of only 5 percent per year for companies going public and only 7 percent per year for companies conducting a seasoned equity offer. Book-to-market effects account for only a modest portion of the low returns. An investor would have had to invest 44 percent more money in the issuers than in nonissuers of the same size to have the same wealth five years after the offering date.IN THIS ARTICLE, WE show that companies issuing stock during 1970 to 1990, whether an initial public offering (IPO) or a seasoned equity offering (SEO), significantly underperform relative to nonissuing firms for five years after the offering date. The average annual return during the five years after issuing is only 5 percent for firms conducting IPOs, and only 7 percent for firms conducting SEOs. While evidence that firms going public subsequently underperform has been documented previously, our evidence that the same pattern holds for firms conducting SEOs is new.The magnitude of this underperformance is economically important: based upon the realized returns, an investor would have had to invest 44 percent more money in the issuers than in nonissuers of the same size to have the same wealth five years after the offering date. Surprisingly, this number is the same for both IPOs and SEOs. While the difference in returns between issuers and nonissuers on which the 44 percent number is based only holds

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“…Hanley (1993) reports that 66 percent of firm commitment IPOs in 1983 to 1987 exercise overallotment options. Muscarella Peavy and Vetsuypens (1992) report similar numbers.…”

mentioning

confidence: 63%

The New Issues Puzzle

Loughran¹,

Ritter²

1995

The Journal of Finance

2,510

723

View full text Add to dashboard Cite

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“…See also Prabhala and Puri (1999). Evidence on the use of the overallotment option can be found in Carter and Dark (1990), Muscarella, Peavy, and Vetsuypens (1992), Hanley, Lee and Seguin (1996), and Aggarwal (1998).…”

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confidence: 99%

When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket

Ellis

Michaely

O’Hara

2000

The Journal of Finance

460

302

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This paper examines aftermarket trading of underwriters and unaffiliated market makers in the three-month period after an IPO. We find that the lead underwriter is always the dominant market maker; he takes substantial inventory positions in the aftermarket trading, and co-managers play a negligible role in aftermarket trading. The lead underwriter engages in stabilization activity for less successful IPOs, and uses the overallotment option to reduce his inventory risk. Compensation to the underwriter arises primarily from fees, but aftermarket trading does generate positive profits, which are positively related to the degree of underpricing.INITIAL PUBLIC OFFERINGS OF SECURITIES are among the most important events in capital markets. By providing access to public markets, the IPO is both the conduit for new capital to f low to f ledgling companies and the mechanism for the existing owners to realize a return for their efforts. 1 The lead underwriter plays an important role in pricing and distributing an IPO, certifying the quality of the issue by his past performance in IPO underwriting. 2 However, the importance of the underwriter continues beyond the IPO date, when he becomes a market maker for the newly traded stock. This paper is the first direct examination of the trading activity of the lead underwriter in the IPO aftermarket.

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“…Given these controversial opinions it becomes important to briefly discuss who would 3 See for instance Hansen, Fuller and Jangjigian (1987) and Muscarella, Peavy and Vetsuypens (1992). See for instance Prabhala and Puri (1998).…”

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confidence: 99%

“…Muscarella, Peavy, and Vetsuypens (1992) compare offerings of stocks to offerings of closed-end funds with respect to whether a GS option has actually been exercised. They find that the amount of underpricing of an issue and the aftermarket price performance are key variables influencing the probability of exercise.…”

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confidence: 99%

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Over-Allotment Options in IPOs on Germany's Neuer Markt - An Empirical Investigation

Franzke

Schlag

2003

SSRN Journal

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Abstract:Over-allotment arrangements are nowadays part of almost any initial public offering. The underwriting banks borrow stocks from the previous shareholders to issue more than the initially announced number of shares. This is combined with the option to cover this short position at the issue price. We present empirical evidence on the value of these arrangements to the underwriters of initial public offerings on the Neuer Markt. The over-allotment arrangement is regarded as a portfolio of a long call option and a short position in a forward contract on the stock, which is different from other approaches presented in the literature.Given the economically substantial values for these option-like claims we try to identify benefits to previous shareholders or new investors when the company is using this instrument in the process of going public. Although we carefully control for potential endoge neity problems, we find virtually no evidence for a reduction in underpricing for firms using over-allotment arrangements. Furthermore, we do not find evidence for more pronounced price stabilization activities or better aftermarket performance for firms granting an over-allotment arrangement to the underwriting banks. EFM Classification: 230, 410Keywords: Over-Allotment Option, Flotation Costs, Underwriter Fee, Neuer Markt * Center for Financial Studies, Taunusanlage 6, 60329 Frankfurt am Main, Germany. Phone: +49-69-242 941 16, Fax: +49-69-242 941 77, Email: franzke@ifk -cfs.de ♣ Faculty of Economics and Business Administration, Goethe University, Mertonstr. 17, 60054 Frankfurt am Main, Germany. Phone: +49-69-798-22674, Fax: +49-69-798-22788, Email: schlag@wiwi.uni-frankfurt Introduction and MotivationSince the mid nineties book building has increasingly replaced the fixed-price method as the standard procedure for setting the issue price in initial public offerings (IPOs) in Germany. Along with this change the instrument of the over-allotment option (also called "greenshoe" option 1 ) has gained considerable importance. An over-allotment arrangement (OAA) typically works as follows. To be able to meet potentially higher demand for an issue, i.e. to be able to place more than the initially announced number of shares, the underwriter borrows additional shares (the greenshoe (GS)) 2 from the company going public. This borrowing of the shares comes with the obligation for the underwriter to return the shares within a fixed period of time, usually one month. In case of a bullish market the underwriter might thus be forced to buy back the shares at a higher price, thereby incurring a loss. An OAA, including a GS option, however, allows the underwriting bank to buy the shares from the issuing firm at the issue price, and this agreement protects the underwriter against unfavorable price movements in the secondary market. On the other hand, a trading profit for the underwriting bank could arise if the stock trades below the issuing price sometime during the life of the OAA, since the underwriter could then buy the sha...

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Optimal Exercise of the Over-Allotment Option in IPOs

Cited by 19 publications

References 1 publication

The New Issues Puzzle

The New Issues Puzzle

When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket

Over-Allotment Options in IPOs on Germany's Neuer Markt - An Empirical Investigation

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