IPO Underpricing: Information Asymmetry Model Proposed By Akerlof

The most important explanation of IPOs underpricing are information asymmetry model proposed by Akerlof (1970). It is based on the discrepancy of the information between, investors, underwriters and issuers. When enterprises go public by issuing shares in stock market, the closing stock price on the first-trading day will reflect whether the investors think the shares worth or not. Adequate and sufficient information is required for each party to decide on the IPOs pricing as to meet their own financial needs.
When enterprises design to offer new issue shares into the stock market for rising of their capital, they needs to guess how much they worth from the investors’ point of view. Also, issuers do not know how many potential investors existed in the market, so they will not set this information as their major
As we know that the information about the background and history of enterprises are one of the important adjustments for them to set up IPOs offering price, enterprises will sell IPOs shares to investors since they need to raise the revenues in maximize. Underwriters in investment bank as an agency will help to calculate the IPOs offer price with the background information about the capital markets and allocation pricing shares. However underwriters can receive the remuneration for services from discount the IPOs issue price as well as underwriting fees, which led to the agency cost theory. This will lead to a problem that underwriters will deliberately decrease the price to reward as commission and ignore the aim to maximize the investors’ wealth. Based on this problem, it will cause a serious catastrophe and it is hard to monitor the agencies activities. So to alleviate this problem, issuers will improve the ranking of successful underwriting activities via IPOs underpriced, as evidenced by Loughran and Ritter