How Syndicate Short Sales Affect the Informational Efficiency of IPO Prices and Underpricing

When a company goes public, it is standard practice that the underwriting syndicate allocates more shares than issued. The underwriter thus holds a short position that it commonly fills by aftermarket trading when market prices fall or, when prices rise, by executing the so-called overallotment option. This option is a standard feature of IPO arrangements that allows the underwriter to purchase more shares from the issuer at the original offer price. We propose a theoretical model to study the implications of this combination of short-position and overallotment option on the pricing of the IPO. Maximizing ∗Bartling, [email protected], Institute for Empirical Research in Economics, University of Zurich, Blümlisalpstrasse 10, CH-8006 Zürich, Switzerland; and Park, [email protected], Department of Economics, University of Toronto, 150 St. George Street (Max Gluskin House), Toronto, ON, M5S 3G7, Canada. Bartling thanks the European Commission’s Marie Curie Fellowship Programme, grant no. HPMT-CT-2000-00056, and the Swiss National Bank for financial support. Park gratefully acknowledges financial support from the Economic and Social Research Council, grant no. R00429934339, from the Royal Economic Society, and from the Montague Burton Trust Fund. Special thanks go to Carolyn Pitchik and Rob McMillan for detailed comments and discussions.