Aggarwal And Conroy-Price Discovery In Initial Public Offerings And The Role Of The Lead Underwriter.pdf

THE JOURNAL OF FINANCE • VOL. LV, NO. 6 • DEC. 2000

Price Discovery in Initial Public Offerings

and the Role of the Lead Underwriter

REENA AGGARWAL and PAT CONROY*

ABSTRACT

We examine the price discovery process of initial public offerings ~IPOs! using a

unique dataset. The first quote entered by the lead underwriter in the five-minute

preopening window explains a large proportion of initial returns even for hot IPOs.

Significant learning and price discovery continues to take place during these five

minutes with hundreds of quotes being entered. The lead underwriter observes the

quoting behavior of other market makers, particularly the wholesalers, and ac-

cordingly revises his own quotes. There is a strong positive relationship between

initial returns and the time of day when trading starts in an IPO.

R ESEARCHERS HAVE DOCUMENTED AND TRIED to explain why IPOs jump up in

price initially but then perform poorly in the long run. 1 Schultz and Zaman

~1994! and Barry and Jennings ~1992! report that almost the entire initial

return is ref lected in the very first trade price. However, researchers have

not examined how the price changes from the offer price to the price of the

first trade. Our empirical analysis explains the learning process by which

the price changes from the offer price to the first trade price. The offer price

is typically set after the market closes on the day prior to the first day of

trading. Yet, there is a large price runup by the next morning. For example,

Amazon.com went public on May 15, 1997 at an offer price of $18 and the

first trade occurred at 10:30 a.m. on May 16 at a price of $29.25. This re-

search is also motivated by the concern of stock exchanges, regulators, and

market participants about the initial price discovery and volatility of IPOs.

Price discovery is particularly important and difficult for the opening of

* Aggarwal is at the McDonough School of Business, Georgetown University and Conroy is at

Folio@ fn #, Inc. Part of this work was done while both Aggarwal and Conroy were at the Secu-

rities and Exchange Commission ~SEC!. We thank seminar participants at the SEC, NASD,

Georgetown University, the 1999 meetings of the European Financial Management Association,

Bill Byrnes, Pat Fishe, Todd Houge, Tim Loughran, Jay Ritter, Pietra Rivoli, René Stulz ~the

editor!, and an anonymous referee for providing very useful comments. This research was par-

tially supported by research grants from Georgetown University and the Capital Markets Re-

search Center. The SEC, as a matter of policy, disclaims responsibility for any private publication

or statement by any of its employees. The views expressed herein are those of the authors and

do not necessarily ref lect the views of the Commission or the authors’ colleagues upon the staff

of the Commission.

1 See Aggarwal and Rivoli ~1990! and Ritter ~1991! for short-run and long-run performance.

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IPOs because no trading history exists. Therefore, the initial trading and

price discovery in these stocks can be very noisy and has become a cause for

concern.

As Ellis, Michaely, and O’Hara ~1999! discuss, the lead underwriter is

always a market maker in Nasdaq IPOs. In its role as a market maker, the

lead underwriter must initially decide at what price to start quoting and

trading the stock. We use unique quote data with the identity of the market

maker to examine the quoting behavior of the lead underwriter during the

preopening period; the behavior of other market makers; the importance of

the preopening period for learning and price discovery; and factors that de-

termine the time of day when trading in an IPO starts. The paper analyzes

how accurate the lead underwriter’s starting quotes are and how he learns

from the quoting behavior of other market makers and decides the price at

which to buy0sell the stock.

IPOs have a preopening period that lasts for a maximum of five minutes

before actual trading begins. During this five-minute preopening period, all

market makers have the option to add, revise, or cancel quotes before trad-

ing actually begins. 2 Nasdaq is examining whether the five-minute preopen-

ing window should be lengthened for some stocks to achieve more efficient

price formation and lower volatility. The argument for a longer time period

is stated by market participants:

The five-minute period wasn’t nearly enough time to gauge the huge

levels of demand that have built for most recent internet deals, and to

determine where the stock would head once it opened.... @T#he new

rules would allow Nasdaq traders more time to determine at what price

an IPO is likely to open. . . ~ The Asian Wall Street Journal , February 3,

1999!

Quotes entered into the system during the preopening period are not bind-

ing. Therefore, it is possible that market makers do not show their true

intention when entering these quotes. They face only the small costs of order

placement and handling without the risk of execution. However, market mak-

ers may have incentives to produce price discovery even in the absence of

binding commitments. The lead underwriter is certainly motivated to learn

from the quote revision process in the preopening. All market makers may

cooperate in the price discovery process because the opening of IPOs is a

repeated game.

There can be a considerable amount of activity during this five-minute

window. For example, there were 116 quote entries in the case of Ama-

zon.com during the five-minute preopening period. We analyze whether these

nonbinding quotes have any value and how the price discovery process works

2 The preopening period is five minutes long during our sample period for all stocks. In

January 1999, the duration of the preopening period was increased for selected stocks. The

preopening period for non-IPO Nasdaq stocks is much longer and lasts for 90 minutes.

Price Discovery in Initial Public Offerings

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even though no trades take place during this time period. The price discov-

ery process starts even before the preopening period begins. The lead un-

derwriter decides when to start trading an IPO and sets the first quote

during the five-minute preopening. This first quote explains a large portion

of initial returns.

A limited number of recent studies have empirically examined how open-

ing prices are determined on the Paris Bourse, the New York Stock Ex-

change ~NYSE!, and on Nasdaq for non-IPO stocks. Biais, Hillion, and Spatt

~1999! find that significant learning and price discovery takes place during

the 90-minute preopening on the computerized Paris Bourse. Cao, Ghysels,

and Hathaway ~2000! conclude that quotes during preopening result in sig-

nificant price discovery for Nasdaq stocks. This limited evidence suggests

that preopening is important, and we expect preopening to be even more

important for IPOs. 3

The lead underwriter has the f lexibility to decide at what time during the

day trading starts in an IPO and he informs Nasdaq of its decision. We find

that most IPOs do not start trading at 9:30 a.m. when the Nasdaq market

opens. For example, actual trading in Amazon started at 10:30 a.m. Almost

half the IPOs in our sample start trading after 11:00 a.m. Underwriters

have certain preferences as to when to start trading an IPO. The opening

time is found to be later for IPOs that start trading much higher than the

offer price.

The rest of the paper is organized as follows: Section I provides details of

the quote-by-quote data along with the sources for other data used in the

paper; Section II discusses the empirical findings; and a summary and con-

clusions are provided in Section III.

I. Data

We use the Securities Data Company’s ~SDC! New Issues database to iden-

tify all IPOs that took place during the period May to October, 1997 and

started trading on the Nasdaq Stock Market. The analysis is limited to IPOs

that start trading on Nasdaq because our objective is to examine the role of

the lead underwriter as a market maker. Unit offerings and American De-

positary Receipts are excluded. The sample consists of 188 IPOs. The SDC

database is used to obtain information on offer price, offer date, offer size,

number of shares issued, and underwriter compensation.

As discussed earlier, quoting in IPOs can start five minutes before trad-

ing. We use a proprietary quote database available at the SEC to obtain

quote-by-quote data during the preopening and also after the market opens.

Quote updates are sequential and include all market maker identifications.

3 Other papers examine the role of stabilization by underwriters ~see Aggarwal ~2000a, 2000b!,

Ellis, Michaely, and O’Hara ~2000!, Benveniste, Busaba, and Wilhelm ~1996!, Chowdhry and

Nanda ~1996!, Hanley, Kumar, and Seguin ~1993!, Logue et al. ~2000!, Ruud ~1993!, Schultz and

Zaman ~1994!, and Prabhala and Puri ~1998!!.

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Table I

Descriptive Statistics on Nasdaq IPOs

The sample consists of 188 Nasdaq IPOs during the period from May to October, 1997. The

table provides mean and median statistics; N is the number of observations; offer-to-open re-

turn is the percentage difference between the opening price on day 1 and the offer price; offer-

to-close return is the percentage difference between the closing price on day 1 and the offer. The

mean and median number of comanagers and syndicate members is also reported along with

the number of different market makers who quote in the preopening.

Mean

Median

Offer price ~$!

12.33

12.00

Issue size ~millions of $!

46.93

34.38

Offer to open return ~%!

17.66

13.76

Offer to close return ~%!

19.47

14.17

Number of comanagers

2.34

2.00

Size of the syndicate

16.85

17.00

Number of market makers entering quotes in the preopening

6.71

7.00

Therefore, we can examine the quoting activity of the lead underwriter, the

comanager, and other market makers. We use this data to create a time

series of best bids and asks because Nasdaq does not report these during the

preopening period. During the preopening, the inside bid and ask are noted

as zero by Nasdaq. Once trading starts, the Nasdaq quote files include an

inside bid and ask. Under normal conditions, the best bid is lower than the

best ask and the difference is the market maker’s spread. However, some-

times the quotes are crossed or locked. A crossed quote is one when the best

bid is higher than the best ask. Similarly, a locked quote is one when the

best bid and best ask are equal. We keep track of locked and crossed quotes.

II. Empirical Results

Table I provides descriptive statistics for the sample of 188 IPOs on Nas-

daq during the period from May to October, 1997. The mean and median

offer prices are $12.33 and $12.00, respectively. On average the first trans-

action is at a price that is 17.66 percent higher than the offer price ~median

is 13.76 percent!. There is only a small change from the open price to the

close price on the first day of trading. The mean offer-to-close return is 19.47

percent ~median of 14.17 percent!. This result is consistent with the conclu-

sions of Barry and Jennings ~1992! and Schultz and Zaman ~1994! that the

opening price captures almost all of the initial return.

The mean and median number of comanagers are 2.34 and 2.00, respec-

tively. The mean and median size of the syndicate is 16.85 and 17, respec-

tively. During the five-minute preopening, on average 6.71 different market

makers enter quotes for each IPO. The maximum number of market makers

quoting for any IPO in the preopening is 14 for our sample. Most syndicate

members do not quote in the preopening; many of them do not even become

Price Discovery in Initial Public Offerings

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a market maker in the stock. Consistent with the findings of Ellis, Michaely,

and O’Hara ~2000!, the role of the syndicate in the aftermarket is quite

limited. On average, the mean number of market makers entering quotes

for each IPO is 12.08 on day 1, 9.97 on day 2, 7.14 on day 10, and 7.72 on

day 20. There are a number of market makers called wholesalers who are

not part of the syndicate but they actively quote in the preopening. Their

role is discussed below.

A. Price Discovery in the Preopening Period

The lead underwriter informs Nasdaq when it plans to open trading in an

IPO. Before trading commences in a stock, there is a preopening period in

which market makers can enter their quotes. This preopening period can be

a maximum of five minutes and a minimum of zero seconds. Nasdaq informs

market participants about the start and end of the preopening period via its

News Frame. The lead underwriter sometimes gives advance notice ~30–45

minutes! about when it wants to start trading, but sometimes it may inform

Nasdaq only a few minutes before the open.

A.1. An Example of a Preopening: Amazon.com

We use the Amazon.com ~Amazon! IPO as an example to illustrate the

preopening process in Figure 1. Amazon went public on May 15, 1997 at an

offer price of $18. The lead manager for the offering was Deutsche Morgan

Grenfell, who started the preopening with a bid at $22.50 and ask at $23.50.

This first preopening quote occurred at 10:25:20 a.m. and the last quote at

10:29:58 a.m. During this four-minute-and-38-second window, 116 quotes were

entered for Amazon by eight different market makers. These preopening

quotes are not binding, so the question is whether they help in price discov-

ery. We find that the quotes continuously changed with prices moving up-

wards during this preopening window. During the few seconds just before

the end of the preopening period, the best bid was at $29.75 and the best ask

at $30. Quotes gradually moved from the $22 to $23 range to the $29 to $30

range. The first transaction occurred at 10:30:02 a.m. at a price of $29.25.

This example illustrates that the lead underwriter’s first quote in the pre-

opening is quite informative and that price discovery also continues to occur

during the five-minute preopening window.

A.2. The Lead Underwriter’s First Quote

The lead underwriter always enters the first quote during the preopening.

Figure 2 plots offer-to-open and offer-to-first-preopening quote ~bid! returns.

The IPOs in the figure are arranged sequentially by initial returns. For

example, the largest price runup in our sample is almost 140 percent, of

which 105 percent is explained by the lead underwriter’s first quote during

the preopening. The lead underwriter uses the offer price as a benchmark

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