Evidence that IPO Prices Have Yet to be Modeled Right

What is it about?

Suppose an economic agent invests in only one asset. Upon arrival of an adverse shock to that one asset, the investor arrives at a loss. If we condition monies for consumption on positive returns to assets, the investor arrives at incapacity for consumption. Suppose, however, that the same investor has access to stock markets, as such can invest in more than one asset, equivalently more than one stock. If the investor invests in assets that are different (e.g. that serve different segments of society), a loss on one asset can be more than offset by a gain on another asset. The risk then, of a loss from aggregation of all investment returns decreases significantly. Absence of stock markets does not preclude investors from investing in companies. In absence, however, of stock markets, it becomes much more difficult for investors to access the best investments in an economy, and identification of firms that facilitate portfolio diversification becomes much more difficult (much less effective) and transactionally inefficient (much costlier). We arrive then at primary benefit of stock markets, namely not just opportunity to invest in companies, but rather access to portfolio diversification which is facilitated by the best investment opportunities that subsist within an economy, as such arrival at a systemic decrease to probability of a loss from investments. In Finance parlance, the desire for investments in stock markets derives from 'risk sharing', equivalently portfolio diversification benefits of stock markets. Since benefits of risk sharing are main advantage of stock markets, pricing of stocks ought be premised on risk sharing benefits of individual stocks, equivalently effects on probability of a loss from addition of a new IPO to an existing portfolio. This study provides formal theoretical evidence that neither of models that already subsist in the peer reviewed academic literature nor models adopted by practitioners premise pricing of IPOs on risk sharing benefits of individual IPOs. Entirety of stock markets then, feasibly are mispriced.

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Photo by Maxim Hopman on Unsplash

Photo by Maxim Hopman on Unsplash

Why is it important?

Study findings do not contradict the well received evidence that stock markets are efficient. The reasoning is as follows. IPO pricing is a one time event that precedes trading of stocks in secondary equity markets. Study findings show efficiency of aggregation of information that arrives post-IPO is not contradictory to mispricing of stocks at timing of IPO. Given mispricing of IPOs devolves from non-pricing of risk sharing benefits of IPOs, as opposed to non-pricing of information on firms' assets and liabilities, efficiency of aggregation of information on a particular stock - equivalently, efficiency of pricing of assets and liabilities - subsists at timing of IPO. Pricing of information on firms' assets and liabilities is, however, a strict subset of pricing of risk sharing benefits of IPOs. In presence then, of efficiency of pricing at timing of IPO, but yet absence of models for pricing of risk sharing benefits of IPOs, regardless an IPO is mispriced. Note that with the Capital Asset Pricing Model (CAPM) only implementable for stocks that already are priced, that neither of market betas nor the CAPM can be applied to pricing of risk sharing benefits of IPOs. If investors are rational, applying study findings, a priori, it ought be expected that stock markets systemically are overvalued. Dichotomies that have been induced between progression of real sectors and progression of stock markets in developed countries, such as the USA are consistent with the prior that stock markets systemically are overvalued. For concreteness, increase in underemployment in the USA from 17% in 2010 to a pre-pandemic realization of 24% unequivocally is inconsistent with a stock market that keeps on delivering new index records. In aggregate, study findings indicate that stock returns tend to be shaped by behavioral, as opposed to rational paradigms exactly because models that ought to facilitate rationality of pricing - models that facilitate pricing of risk sharing benefits of IPOs - have yet to be formulated. In absence of guardianship that, otherwise is facilitated by the missing models, investors are guided by subjective beliefs. Stock returns become subject then, to 'power laws', that is, forces of subjective demand and supply. Clearly, we arrive at socioeconomic importance of formulation of models that facilitate pricing of risk sharing benefits of IPOs. There exists one such work-in-progress that, at the present time, is yet to be peer reviewed published (see resources link).

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