The National Stock Exchange Finance Essay

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Introduction

IPO underpricing is found in almost every country of the world. Almost all markets in the world have been reported short-run underpricing (see Loughran et al (1994) for a comparison of 25 countries).Since the scandal of 1992 where the Sensex have reached its bottom level ,there has been structural changes in both primary as well as secondary market. After the development of capital market of India & also the deregulation of economy in the year 1992 there has been lots of upward & downward movement in the capital market. In this paper we will examine that why are IPOs underpriced in NSE (National Stock Exchange) & BSE (Bombay Stock Exchange) with respect to their fair value. The National stock exchange is the largest exchange in India for both equities & derivatives trading in terms of both volume as well as also in number of trades & also the first fully demutualized stock exchange of India whereas Bombay stock exchange is one of the oldest stock exchange of Asia which is known as "BSE" which was established as "The Native Share & Stock Brokers Association" in 1895. The exchange of BSE is managed professionally by Board of directors which comprise of Trading member Directors, Shareholders Directors, Public Interest Directors, and MD & CEO of Exchange & Non- Executive Chairman. In terms of number of company listed BSE is worlds number 1 exchange & second in obtaining an ISO certification 9001:2000.BSE include 30-stocks index which comprise large stocks & companies from different sector whereas NSE include 50-stocks index. Studying IPOs in Indian market is because that in the world India is the first country to launch a rating mechanism for Initial Public Offerings (IPOs) before their listing. IPO coming to Indian market are graded ranking from 1 to 5; in which 1 is poor performance where as 5 is a strong performance. Grading of IPOs in Indian market is compulsory. SEBI (Securities & Exchange Board of India) was established in 1988 & a statutory power armed in 1992 & is the market regulator of India who keeps informing the investor about the firm's fundamentals & also where they are making their investment. Now stock market of India is ranked 1st in stock futures whereas 4th in index futures within 5years of introduction of derivatives. Not more work has done on Indian IPOs but out of that most of the analysis has been done by Madhusoodanan & Thiripalraju (1997).This study carried out all IPOs which are listed on BSE & NSE during the period 2009-2010.Other papers of short run performance of Indian IPOs are by Narasimhan & Ramana (1995) who has analyze 103 IPOs performance, while 2056 IPOs performance was conducted by Ajay Shah (1995) whereas 495 IPOs sample was analyze by S Uma (1995). The aim of this study is to examine the underpricing use by the most esteemed investment bankers when they handle the issue whereas the process to analyze the pricing mechanism of Indian IPO issue. Another concern of the paper is first day underpricing in terms of demand generated during the book building of issue whereas there are also sometime delay in listing from the closure of issue & lots of money are spend on marketing by the firm on IPOs. This study will also find that on an average of 20 days in delay exists between the offer closing & the listing of firm, because of which there is a possible market trade off happening before the listing of issue if that issue has priced at the higher end of the band. By delay of listing it has positively influence the degree of underpricing. IPOs are the securities which are sold to public in the primary market. When investors has been allotted a share at the time of IPO at a lower price & if he sells it at the higher price on the first day of the listing with a gain, this phenomenon in IPO market is called as "Underpricing". The more the Underpricing, more is the money made by the investors who got allocated with a share & sell it on the listing day, it's also referred as "money left on table" by the firms. ICICI was the first company to exercise book building mechanism in 1996 for its 1000 crores of bonds. With introduction of the FERA(Foreign Exchange Regulation Act) in 1970s a new phase began in stock markets of India which led to disinvestment of foreign equity by MNCs(Multinational companies) which a creation of surge in retail investment. Unlike US, where they preferred book building method of IPO pricing for many years whereas Indian market were not using this method until 1999.However by 2006-2007, major IPO share price using book building mechanism which has dominated fixed price methods. There is some differences in the fundamentals of US book building issues & Indian book building issues where the biggest differences is in terms of transparency & also in dispersion of information. There is also difference in Indian regulatory system. Currently Indian capital markets have both book building as well as fixed price mechanism. The most basic problem of IPO process is asymmetric information between firm & investors which can also suggests that IPO underpricing can be avoided if information is well provided to investors. The results suggest that IPOs are mostly underpriced, but book building IPOs are less underpriced than fixed issue price. The mobilization of capital of Indian IPO market was increased sharply from Rs.1704 crores to Rs.13, 443 from 1990-91 to 1993-94, but this trend was drastically declined when Indian companies raised only Rs.5, 732crore in 2003-04 from IPO. Then the condition improved in 2004-05 when Indian IPOs raised Rs.25526 crores whereas there is also an unsteady trend for the number of firms going public. A total of 1428 firms went public in 1995-96 but after that in 1997-98 only 62 firms went public & the trend continued for the later period also where 102 firms went public in 2005-06 as compared to only 54 firms went public in 2009-2010.For overall functioning of capital market a steady level of activity is necessary in primary market. We will also find the performance of post IPO in 1months after the listing of issue & the remaining paper structure is follows: section II Literature review, section III Methodology, section IV Models , section V will be collection of data, section VI will show the results & section VII conclusion.

Chapter II: Literature Review

The literature review for the study can be divided in following parts: Reasons & Timing for going public: Going Public refers IPOs (Initial Public Offerings) of private companies which becomes available traded publicly & also owned entity. The future plan of growth, venture, expanding can be increased by support of equity. There are various merits & demerits of going public, merits are that capital base would be strengthens whereas there would be increase in prestige and also diversifies the ownership on the whereas demerits such as there is pressure on short term growth of firm, increases in the cost & also the restriction on management. According to Brealey and Myers (2005) in the initial year only, a USA firm seeks private equity & after that only they go public. The study of Italian firms by Pagano, Panetta and Zingales (1998) found that firms only rebalance their account after their huge investment but they don't seek money for growth. There is reduction in investments & also in leverage during post IPO period. Thus for firms life cycle going public is not a natural elements. They have also stated that some firms prefer to be private rather than to go public. The advantages & disadvantages of book building & auctions can be studies in the paper of Kenji and Smith (2004) as the methods of issuance of IPO in Japan. The reason behind choosing Japan for their study was that since 1997 in Japan it's a legal way to go public. Valuation of IPOs: Purnanandam and Swaminathan (2002) say that priced of IPOs are almost 50% higher than that of industry peers. They also found that in respect to peers most of IPOs are overpriced whereas in long terms performance its worse. According to Benveniste and Spindt (1989) found that asymmetrical information between the investors & the firms which provides investors an incentives to reveals the firms secret information are tried to resolve by the underwriters. The other study which led by Gary Koop & Kai Li (2001) found that factors of pricing influence the valuation of IPO whereas theories regarding the reputation on underwriter are not supported in their empirical result. They also examine the IPO pricing by using stochastic frontier methodology. All other things remains equal, IPO firms are underpriced & firms in industries which have more potential earnings are highly valued. According to the study by Kim & Ritter (1999) which includes 190 firms, it tries to say that for getting appropriate price of IPO underwriters forecasts the number of earnings of next year & then multiply them with the PE ratio of firm comparable with the same industry. Allocation mechanism: Allocation mechanism by the regulators is specified in various countries. The model predicts by Benveniste and Spindt's (1989) says that the degree of underpricing can be reduce if its allowed underwriter to differentiate between the investor who have more information then that of firm to those investors who are offerings large numbers of shares. Other study by Loughran, Ritter and Rydqvist (1994) found 3 different categories across various countries i.e. Auctions, Book Building & Fixed price whereas study of Sherman (2005) found that for selling of IPOs, book building mechanism is superior to auctions. His models is procedure of book building process in respect to auction which tries that why auction is given way to book building mechanism. Theories explaining Underpricing: IPO underpricing has been found as a key mechanism across the capital markets of the world for last many numbers of years.There are various numbers of studies which explain underpricing of IPOs. Some of the prominent theories have been discussed below: Leland and Pyle's model (1977): According to this model which says that asymmetry information between the investors & those of IPO issuers can be reduced by looking at the signal of equity which can be retained by the issuers. Leland and Pyle's are the first one who suggested that to resolve information asymmetries for which financial intermediaries are important. Pande, A. & Vaidyanathan, R.: Pande, A. & Vaidyanathan, R. (2008) has explains the pricing of IPO in NSE (National Stock Exchange) & also sought to understand the pattern of emerging Indian IPO market whereas the reason given behind this was underpricing of first day trade compare to demand generated during the book building issue & also the money spent on marketing of IPO. Through this it was found that the gains are scattered within a month whereas oversubscription of issue is not the correct indicator for underpricing. They also found in this study that performance of IPO after the listing is negative in one month's period. Their study has given focus on pricing of IPOs. Benveniste and Wilhelm (1990): According to Benveniste and Wilhelm (1990) paper they proved that investment bankers the price combination & also discrimination allocation to maximize their proceeds. The author also analyses that to place the issue underwriters are forced to under-priced the issue for the investors whereas the investors who are well informed compensate it. With the services of investment bankers to the investors, underwriter can reduce the underpricing with the bundles of allocation of IPOs. Loughran, T. & Ritter, J.R. (2003): Loughran, T. & Ritter, J.R. (2003) has described how underpricing of IPOs has been changing from time to time, depending on environment such as winners curse problem, internet bubble, dynamic information & also the underpricing during the changes of period. The study also explain the cross sectional relation between the measures of valuation & first day return & he also found the negative relation between underwriters prestige & underpricing in 1980 which later focus on maximizing IPO proceeds due to allocations of hot IPOs. They also founded that the firms which went public during the period of 1990-1998 has $8 billion of the total earning & the amount left on table was $27 billion even after paying underwriters fees i.e.$13 billion. Rock's model of Winner's Curse problem: For firms commitment offerings Rock's model is been used. He also showed that investors who are more informed of the overpricing of issue withdraw the issue, leaving investors who are not informed with winners curse problem. Thus investors who don't have any information do not participate in the issues which are over priced. Therefore firm must underprice their IPO to attract such investors. Acquisition of Information: For Book building, model is given by Benveniste and Spindt's (1989) whereas they also predict that to acquire information from the investors who are more informed of issue for that underpricing is necessary & also the price band which is at the higher end of book building issue are more underpriced than that for lower end of issue. Later, Ellul, A. & Pagano, M. (2006) explain that after market liquidity is also a worry for investors which leads to asymmetric information & the main determinants of underpricing is after-market liquidity & liquidity risks which was founded by them through various measures. They said that risks & information asymmetric is the explanation for the IPO underpricing. Their model supports the study for 337 British IPOs from the period of 1998-2000.For the findings of liquidity risks & after-market liquidity which are the main determinant of underpricing of IPO, they have used many measures of liquidity. Signaling Hypothesis: If investors have less knowledge than the firm about its prospect than the assumption of Signaling Hypothesis. According to Allen & Faulhaber (1989),which he found that in a rare circumstance firms which have better image gives "signal" about their prospect to the investors & they underpriced their IPO. Other theory of Ibbotson (1975-pg264) says that firms also underprice their IPO for their future seasoned equities for which they can priced higher. Underpriced of IPO will leave a better taste on the mouth of the investors. By adding to this, Grinblat & Hwang (1989) model explain that firms shares are retained in their own portfolio & issuers signal better quality of IPO by the mode of underpricing. In the paper of Ritter (1984), in which he used standard deviation for a risk as a proxy on after market returns whereas he also found that there is a positive relationship between the degree of uncertainty & the initial returns on true value of securities. Rock's model is also consistent with the above, which also predicts that there is a positive relation between the initial return & the risk. Subsequently the paper by Jegadeesh et. al. (1989) and Brennan & Franks (1997) which they also used the standard deviation on IPOs company for the stock returns which is just after the listing about the true value of the securities. The evidence founded by Ljungqvist and Wilhelm (2002) tells that underpricing is related directly to information production whereas acquisition of information promote to allocation discretionary. They have also found the evidence which supports an efficient process of book building.There is a thought which is related to semi-strong & strong form of market efficiency, according to Boulton, T.J. & Smart, S. & Zutter, C.J. (2008) found that where public firms produce high quality information than IPO underpricing will be less in that country whereas going public is offset by good quality underwriters, in which financial intermediaries play a vital role in earning quality of underpricing. If there is more difficulties to interpret financial information by the investors, then there will be increase in cost for going public & also says that underpricing is affected by earning quality. They have examined 7,306 IPOS across 34 countries from which they found that when high quality of information earnings are available to the existing firms which are public than in that countries IPO underpricing is less compare to those of other countries. Regarding market efficiency, Benveniste, L.M. & Fu, H. & Seguin, P.J. & Yu, X. (2008) have investigated efficiency of IPO market by using the sample of equity carve-outs & the evidence interpreted by for the result is consistency with market efficiency whereas they found that parent return of the first trading day return in significant manner is related to the book building period. In this study IPO market efficiency is examined by the pricing performance, economically as well as econometrically their result are not changed. The hypothesis has been challenged by various studies which conclude that if information is available publicly than they can earn more profit. Li, M. & Zheng, S.X. (2008) examine that non-block institutional shareholders in number are positively correlated to that of underpricing, but in case of changes in total number of shareholders its negatively correlated whereas there is high liquidity in secondary market which can be more from more non-block shareholders. For example Chambers, D. & Dimson, E. (2009) has analyze the equity data set which research has rectified that the pattern of underpricing is consistent in stock market & also if there is any improvement in regulation, disclosure & honour of IPO underwriters increased in underpricing has not attributed to the change the composition of firm & also the study observe that the investment bankers maintain the issue method to mitigate underpricing which impact the equity market whereas Lowry, M. & Murphy, K. J. (2006) clarifies that executive on top level receive net gain due to underpricing because executive receives stock option with the same exercise price that of IPOs offer price & it found that relation between underpricing & stock option has not been success but expect that, there is a positive relation between this two & also their result are consistent with parties such as underwriter, Board of Directors which have more influence than the executives. There study also tells that during the IPO period of 1996-2000 executives of US received the stock option with the price less than that of market determined. Chang, E. & Chen, C. & Chi, J. & Young, M. divides paper in primary & secondary market showing the initial IPO returns & the evidence shows that primary market's initial returns has negatively related to subscription whereas secondary market in relates to market returns is significantly positive to IPO offerings & also the turnover is negatively related to the size of the offerings. It also focuses on the first trading of IPO in secondary markets & demands are also not the same in both the markets. There is a link between ownership structure & underpricing of IPO, Field, L.C. & Sheehan, D.P. (2004) says that according to Brennan & Franks(1997) oversubscription are encourages by underpricing & according to Stoughton & Zechner (1997) to encourage investments from the block holders mangers underpriced IPO whereas he says that there is weak relation between ownership structure & underpricing. They also said that there is no difference in the firms who are not underpriced & also who are underpriced in terms of acquiring of new block holders. They used regression model & reveals with the analysis that on outside block ownership there is no effect or might be little, then Hopp, C. & Dreher, A. (2007) analyzes found that deviation in underpricing contribute negatively because of larger accounting transparency & increased protection of shareholders which conclude that institutional environments & good quality investors protection brings down the risks of investing whereas it also reduce the problem of asymmetric information resulting in lower underpricing overall. The result shows that if the return of market is higher than the underpricing also increasing significantly. It does also investigate the importance impact of underpricing & also the development of equity capital market. Overall evidence of this study found variation in underpricing. Hearn, B. & Filtochev, I. (2010) research studies the difference in protection of laws & governance system which influence IPO underpricing & evidence found that strength of investors protection law is positively related to underpricing .The result suggest that discount in IPO is almost in many countries with powerful outside public market investors protection & also the rights of property which is also consistent with hypothesis of governance quality. They has used the data base of locally listed 198 IPOs all over Africa & found the difference between civil & common law. Another study by Aggarwal, R.K. & Krigman, L. & Womack, K.L. (2002) conclude that manager wait till the lockup period end whereas they don't sell any of their shares in IPO because their strategic is to sell shares at lockup expiration & generate their own personal wealth. The model also found that managers ownership are positively correlated by the first day trading underpricing, whereas underpricing is correlated positively to research coverage & research coverage to returns of stocks whereas Nagata, K.& Rhee, S.G. (2009) study examine the structure of ownership whether & how affect the decision around IPOs using the data of new issues in Japanese & the result suggest that structure of ownership is related to the offer size of IPO & also the magnitude of underpricing & also says that difference in structure of ownership can be the determinants of underpricing of IPO. In the context of Indian, there are studies on IPO underpricing which has been done by Shah (1995) on Bombay stock exchange & Pande& Vaidyanathan (2008) on National stock exchange whereas many others have also concentrated on IPO underpricing. This paper will concentrate on data which consists of 54 IPOs that got listed on both in National Stock Exchange (NSE) as well as on Bombay Stock Exchange (BSE) over the period of 2009-2010 which includes both book building & auction IPOs & which will study the changes in the evolution of IPO market & also the regulations whereas it will also find out that is still book building more superior than fixed price or not. It will secondly look on the large demand on issue which is generated during the book building & the important factors that for which there is delay in the listing of the issue & also lots of money are spent on marketing. Thirdly & lastly its will also look to study the one month returns after the listing of issue to see whether the underpricing is been there for the period of one months or not.

Chapter 3: Methodology

This study would try to verify the following 3 hypotheses which are as follows:

Hypothesis 1: The underpricing in issue will be more if the issues is priced at the higher side of the price band then the issues which are priced at the lower side of the issue price band.

In the capital market of IPO the popular function is degree of underpricing. According to Benveniste and Spindt (1989), in the scenario of book building the investment bankers are those who fixes the offer price, which is based on the demand generated in the market. If the demand for the issue is not good (i.e. not up to marks) which investment banker thinks than that price of the issue is fixed at the lower end of the price band whereas in the opposite side if the demand for the issue is more than the expected then the price fixed for the issue would be at the higher side of the price band. The price which is fixed at the higher side of the issue gives a better signal for the investors by the firms intimating them about the better demand generated from the market for the issue & which would result in better listing price as well as also in the trading price on the day of listing. But, Cornelli and Goldreich (2001) has shown that by the intersection of demand & supply curve the price cannot be arrived so the demand may exceed the supply in the book building issues. The curve of demand where shows the steepest descent is in fact the price which should be fixed. Thus the price which is fix in the above mentioned manner by the underwriter could be the appropriate for a signal for underpricing whereas oversubscription of issue would not be a credible signal for underpricing of issue. Normally, between the fixation of price & trading day for the issue there is a period of 2weeks in which market players can form various strategies for the day of listing. Hence the 1st hypothesis which says that higher side of the price band of issue are more underpriced then the lower end of the price band is being examined.

Hypothesis 2:The degree of underpricing would be lower if there is more delay in the listing of the issue by the firm.

Unlike the US markets, there is a delay of about 3weeks in the Indian stock markets from the closure date of the issue & listing date for the issue. Therefore the delay in listing is a function hypothesized to the degree of underpricing. The expectation for the firm is revised if the firm is getting longer time for the listing from the date of closure. Thus, if this happens then the market speculates that there is some problem in clearance of the project from the various authorities whereas the firm can face lower degree of underpricing or it might also face over pricing at the day of listing. In case of investors who face illiquidity due to the longer period for listing will demand more premium on the day of listing & they may take their positions in the market, (Shah, 1995).Moreover, if there is substantial gap between the listing date & closure of issue then there might be possibility for out of the market trade in larger number. Thus its not clear that whether the listing delay affect the degree of underpricing positively or negatively.

Hypothesis 3:If the larger part of issue proceeds are spent on the marketing fees then the firms degree of underpricing would be less.

In the paper of Habib and Ljungqvist (2001) which they have postulated that underpricing is been affected by the cost of promotion. Underpricing & promotion cost as been viewed as substitute costs for the company. If promoters want to sell more of their shares, then the money spend on the promotion of that issue will be more. As per the result founded by them shows that promoter wealth are reduce by 98 cents for promotion costs of every 1$,therefore the marginal benefits of the promotion equals to the marginal costs. Whereas Cook et al (2006) found that if investment bankers are unable to generate more of their pre-offer publicity then the issuers tend to change the investment bankers. More individual investors tends to hold stock if it's of high visible firms which was founded by Frieder and Subrahmanyam (2004). Higher visibility can be done only by spending higher money for the marketing of the firm, with all other things remaining same the degree of underpricing must be lower. In addition to this hypothesis this study would also try to find out the firms return i.e. one month after the issue is listed.

Models

The firms delay in listing is been measured in a days as the time period i.e. from the last day of closing of issue to the day of the listing. Logarithm is been used to measured the marketing expenses which is spent by the firms in the Indian rupees. The degree of underpricing is been measured by dividing the data sets in to 2 parts i.e. by taking the mean of the price band. It is classified as follows: a) High demand issues whose offer price is more than the mean of price band, b) Low demand issues whose offer price is lower than the price band of issue. For e.g. If the price of the issue which is bid is 220 Rs. or more in the price band of 200-210, then the issue is been classified as the high demand issue or else it been classified as low demand issue. After that a dummy variable demand has been used as the OLS regression with a value of 0 if the demand for the issue is low otherwise value of 1 if the demand for the issue is high. The ratio of difference between the offer price of issue & the closing price of the issue at the day of listing has been used to measured the degree of underpricing. Degree Underpricing=(P close on listing day - PIssue)/PIssue .Here P is referred as price of stock. Since the degree of underpricing can be affected both negatively & positively on the listing of the day by the volatility of market wide, therefore the change in percentage of various companies on the day of listing in S&P CNX Nifty 500 index is included as the 1st control variable. The Second control variable included is Issue size, because firms with the low degree of underpricing comes with the large issue size signaling the quality whereas it negatively affect the size of an issue. To avoid heteroscadisticity natural log was taken for an issue size. Then the regression model estimated is as follow:

Degree of Underpricing: ß0+ ß2 (Delay in Listing)+ ß3(ln_Size of Issue)+

+ß4(ln_marketing expenses)+ß5(percent change in market)+ ε

Here error term with N(0,1) is ε
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