FIN-03-038

What makes issuers happy? Testing the Prospect Theory of IPO Underpricing

December 2003

Alexander Ljungqvist and William J. Wilhelm, Jr.

ABSTRACT
We derive a behavioral measure of the IPO decision-maker’s satisfaction with the underwriter’s performance based on Loughran and Ritter’s (2002) prospect theory of IPO underpricing. We assess the plausibility of this measure by studying its power to explain the decision-maker’s subsequent choices. Controlling for other known factors, IPO firms are less likely to switch underwriters for their first seasoned equity offering when our behavioral measure indicates they were satisfied with the IPO underwriter’s performance. Underwriters also appear to benefit from behavioral biases in the sense that they extract higher fees for subsequent transactions involving satisfied decision-makers. Although our tests suggest there is explanatory power in the behavioral model, they do not speak directly to whether deviations from expected utility maximization determine patterns in IPO initial returns.

Alexander Ljungqvist
Institution: Stern School of Business, New York University
Phone: (212) 998-0304
Fax: (212) 995-4233
Email: aljungqv@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~aljungqv

William J. Wilhelm, Jr.
Institution: McIntire School of Commerce, University of Virginia

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