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Non-Sustainable Demand for New Stocks, Learning, and IPO Pricing

When the market undergoes a learning process about a new issue, it takes time for the aggregate demand to converge to the equilibrium consistent with the stock’s underlying fundamentals. As a result, the early market demand can deviate significantly from the sustainable demand. This problem requires the underwriter to react differently to varying pre-market conditions: while he has the option of partially responding to investors’ overly optimistic views for a hot IPO, he must accommodate the overly pessimistic views of investors for a cold IPO. We model IPO pricing in such a setting and derive predictions for IPO initial return and post-issue performance. We provide supporting evidence for the model.