Underpricing in the IPO market with sentiment traders: An experimental study

Ljungqvist, et al [2006] explore the model including sentiment investors and derive both underpricing and underperformance results of IPO pricing endogenously. In their model, there are some sentiment investors who have excessive expectations and buy the stocks at a higher price. This initially causes underpricing, and then leads to further declines as they revise their naive estimates, which leads to underperformance.

At first glance, the underpricing results may be theoretically obvious because sentiment investors buy stocks at higher prices than their fundamental value. But their important theoretical contribution is that underpricing still occurs even if the underwriter has no bargaining power, which means that the IPO price could be equal to the stock price, which is not underpricing, even if sentiment investors buy at a higher price than the fundamental value. Although sentiment investors tend to buy the stock more than the fundamental price, and the price could be higher than the fundamental value, such an expectation could change when the bubble crashes, and the price could go down to the fundamental value thereafter. Considering the possibility of bubble crash, the IPO company must set the IPO price equal to the expected value, which could be lower than the stock price.

If there is no crash, the IPO company can sell the stock at the same price as the market price and there is no underpricing. If crashes occur, on the other hand, the IPO company must sell the stock at the expected value, which is lower than the initial prices, so underpricing occurs.

This is the main logic of Ljungqvist, et al [2006] in which underpricing occurs or not. And it is mainly based on the amount of initial shares that the IPO company sells to the underwriters at the beginning. If the amount of initial stock is smaller than the demand of sentiment investors of the market, there is no uncertainty and underpricing could not occur. If the amount of initial stock is larger, on the other hand, the underwriter should sell the remaining stock at the second stage of the market, even if the bubble could crash and the price could go down to the fundamental value, because selling all the amount at the first stage will make rational investors buy stock and the price will go down drastically. So the underwriter has to wait for the remaining shares to be sold in the next phase. Then underpricing occurs.

We verify the results through experiments. In the experiment, IPO company is exogenous, and we hire the subject assigning the role of underwriter who sells the stock in the market. As Ljungqvist, et al [2006] assumed, the subject has two chances to sell the stock. Namely, the market opens twice and they can sell the stock twice. The investors, whether sentimental or rational, are price takers and exogenous. And the price is set automatically.

From their proposition, if initial stock amount is smaller, underprice does not occur, while large, it occurs. And we use two conditions: small amount and large. In addition, the probability of crash is considered important. So, other condition is higher probability or lower probability that bubble will continue. Thus, we introduce 4 conditions. In the experiment, both IPO company and investor are assumed to be exogenous. And we hire the subjects who assign the role of underwriter. In the experiment,

Timeline of Ljungqvist, et al [2006] model and our experiment is as follows
1. The IPO company (exogenous) offers the number of shares to be issued and sells them to the underwriter (endogenous) at the price equal to the expected average price of the market.
2. Underwriter (subject) sells shares in the open market (open for two periods) in order to maximize their profit. The price of the market at the first stage as well as the second state is determined by the total initial stock and crash probability,
3. After selling the stock, the underwriters' profit is revealed and they get the reward.

The experiment involves an exogenous IPO company and participants fulfilling the role of underwriters, who sell shares across two or three market phases, seeking to maximize profits. The experiment considers variations of the perceived probability of a market crash and in the initial quantity of shares assigned to underwriters(subjects). Market participants, both sentiment investors and rational investors are exogenous, automatically calculated priced based on demand function and the stocks. Four conditions are outlined for the experiments: low and high quantities of shares, paired with low and high probabilities of continuing market bubbles. Based on the parameter, subjects sell their stocks to maximize their benefit.

In the open market, both sentiment and rational investors, who are both price takers, buy the stock market. Sentiment investors tend to buy higher price than rational investors. price is higher when selling stocks are less than or equal to the demand of sentiment investors at the first stage than selling stocks is more than the demand. Therefore, the underwriter should sell the stock less than or equal to the demand of sentiment investor in the first stage and sell the remaining stock in the second stage if it maximizes the profit. Thus, it is key point in the experiment to ensure whether subjects(underwriter) is tolerant enough to wait to sell the stock to second period when they are assigned large amount.

2024-11-28

2025-01-12

Four conditions are outlined for the experiments: low and high quantities of shares, paired with low and high probabilities of continuing market bubbles.

We conduct the pilot experiment in February 2024 at King Mongkut's Institute of Technology Ladkrabang in Bangkok. Thailand. In pilot project, assigned stock is more and demand function is more complicated. But important point is the same as the main experiment. Subjects in Bangkok were required to be more tolerant than the main experiment, because they sell more stock. And the result is surprising that most of them are tolerant enough to sell the second period to maintain higher price at first period.

First we gather the subjects mainly from University students, both Kansai University and King Mongkut's Institute of Technology Ladkrabang University based on the procedure admitted by research ethics committee. After arriving at the experiment venue is as follows.
1. Explanation and collection of the consent form and withdrawal of consent form.
2. Explanation of the experiment (about 20 minutes) , practice and confirmation test using Ztree to enter the values specified by the experimenter and check the screen display (you cannot proceed until you get the correct answer, about 15 minutes)
3. Main experiment (about 60 minutes) (Note that Ztree does not support Thai, so the experiment is conducted by displaying the English screen and the Thai PDF file while Ztree support Japanese, so there are no additional documents in Japan.)
4. Completing the receipt and paying the honorarium
5. Dissolution
The experiment supervisor will strictly manage the personal information obtained, and after 10 years of publication, all documents and other materials will be destroyed.

We provide 4 types of experimental condition at pilot experiment, many or few shares for IPO firms to sell underwriter (subject), and low or high probability of continuing bubble. In all cases, underpricing occurs, and subjects sell less or equal shares to the sentiment demanded by investors in the first period even with high probability of crash. We conducted pilot experiment in February 2024 in Bangkok. Considering the pilot experiment, we will conduct main experiments both in Japan in December and in Thailand in January.

we gather the subjects that are ordered randomly.

both Kansai University in Japan and King Mongkut's Institute of Technology Ladkrabang in Bangkok.

Yes

4 times 3, total 12 clusters each clusters contain 25-45 subjects.

12 times around 40 subjects means around 500 subjects, mainly university stundets of both Kansai University in Japan and King Mongkut's Institute of Technology Ladkrabang in Bangkok.

500 students.