IPO Impact on Stock Market Volatility

Abstract

Initial Public Offerings have been used for a long time to fund the future expansion projects of a company as and when the need arises. At the same time, Initial Public Offers do have their limitations and adverse effects, such as, dilution of ownership of the business and the expensive nature of carrying out successful Initial Public Offers and most importantly the introduction of stock volatility to the stock market. This paper looks at the impact of both major Initial Public Offers and minor Initial Public Offers on the stock market. The paper further reviews literature on the period during which market volatility lasts in the market and the recommendations for control of market volatility, due to Initial Public Offers.  Finally, the paper gives issues that should be further discussed and a conclusion on the subject.

Introduction

Order custom essay IPO Impact on Stock Market Volatility with free plagiarism report

450+ experts on 30 subjects Starting from 3 hours delivery

Get Essay Help

Volatility is the behavior of a stock market where the prices rise or fall steeply within a relatively short period. The rising volatility, usually from the trend, shows that the market is declining and is accompanied by the decline in prices.  Falling volatility, they explain, shows that the market is appreciating and that it is usually accompanied by the increase in prices.

There are several factors that affect stock volatility. There is a strong inverse relationship between stock prices and inflation. As Jonathan explains, that high levels of inflation lead to low stock prices and low levels of inflation lead to high stock prices.  He also adds a third factor that influences stock volatility is the economic strength of markets.  There is a common trend where the prices of stocks of a similar sector move together, this is the reason that many investment firms are of the view that the sector movements dictate the stock prices.  An illustration is where negative performance of one stock affects the other adversely, simply because the two stocks are related.  This may even end up adversely affecting the whole sector and cause high stock volatility (Jonathan 1997).

Fear and greed affect the market in the following way; when new or important information comes into the market, these qualities make investors either sell or buy stocks, which makes volatility either rise or fall according to the circumstances.  For instance, if it there is speculation that stock of a given company is likely to rise, greed makes investors purchase large values of stocks, which leads to stock volatility.  This is due to the fact that the investors might dump the stocks of other companies in a bid to purchase these shares.  On the other hand, if there is new information that the political situation in a given country is likely to get worse, or there is a likelihood of war, fear takes over.  This may also be the case where there is speculation that stocks of a given company will fall in value, in the near future.  The investors dump shares, in both instances, which leads to cases of stock volatility.  This is arguably the most important factor that determines market volatility at all times, since the market trends are based on speculation, which leads to either fear or greed in humans.

An Overview of Stock Market Volatility and IPO Impact

Normally, when investors participate in IPOs, they mainly rely on speculation, says Wang. This is because, in primary IPOs, there is no information on the performance of the company undertaking the IPO.  He further explains that information is not available since most companies engaging in IPOs are in transition stage, and the future performance is difficult to predict (2005: 919-972). Torben’s research has proved the existence of a positive relationship between trading volume and price volatility. The study undoubtedly proved that high trading volume will most likely lead to high price volatility and vice verse. (1996: 169-204).

In an Initial Public Offering (IPO), a company sells shares to members of the public (Weiss and William 1995: 4).  This is mostly done to primary shares, although sometimes it involves secondary shares.  The Initial Public Offer is usually handled by stock market experts who have experience in fixing the IPO price.  If they predict that the offer price will be below the expectations of the company offering it, the IPO is postponed to a more appropriate date.  After the launch of the IPO, the shares can be traded through the stock exchange.

The view of Richardson is that when the IPO trading commences, many people overvalue the company and off-load the shares they had in other companies thus this trend leads to the overall performance of the market declining (2003: 1113-1138). Some emerging markets have shown low levels of volatility before IPOs , and the observation can be explained in two ways.  One is that the investors may be too liquid, such that they can participate in the IPO, without necessarily selling their existing investments.  Another reason may be that, there are many new investors who are starting to invest, such that there is little or no effect on volatility. One trend that is emerging from the IPOs is the 'quiet period', which is about twenty five days after an IPO. However, the US government extended this period to forty days, from twenty five days, in 2002.  The underwriters and insiders of the company are prohibited from mentioning anything that is not in the company prospectus.  They are also barred from carrying out research about the company.  The purpose of the quiet period, is to give investors time to do assessment and let market forces work without interference.  Towards the end of the 'quiet period', most investors anticipate the purchase of the stocks mainly due to advice from the underwriters.  This normally begins at about ten days before the expiration of the 'quiet period'.  This results in increase in trading volume and subsequently a sharp increase in price of the stocks.  If the market is efficient, the expiry of the 'quiet period' should not lead to abnormal returns.  The 'quiet period' leads to high volatility and investors are advised to hold the shares until after the period (Mohan 2000: 673).

Another factor, during the IPO, that affects the volatility of the market is the 'lockup period'.  This is the time limit that insiders of a company are restricted from selling their shares, after an IPO, depending on the instructions on the prospectus.  Most companies have a period of  at least six months in the case of large shareholders.  The purpose of a 'lockup period' is to allow for the market to develop on its own.  This is more so because the stakeholders get the shares at a discounted price and stand to gain the most.  After the expiry of that period, they are allowed to trade their shares according to the limits set by the Stock Exchange. According to Bradley & Jordan (2000: 465-493), most insiders sell their shares after the expiry of this period.  Ten days after the lockup expires, there is an high increase in trade.  This however depends on the shares unlocked, and the higher the shares unlocked, the higher the likelihood of sale of the shares.  This may be explained by the perception that investors have, that the offloaded stocks, are an opportunity for repurchasing.  This then leads to a rebound in volume traded, some days after the lockup expires.  This works very well when the shares unlocked exceed 25% of market capitalization.

IPO Influence on Stock Market Volatility and Existing Assets Pricing

Size can be one of the characteristics of IPO that affect the prices of the existing assets. Major IPOs are more likely to lead to high volatility, explains Allen and Faulhaber, this is because, when the company, which has good reputation, is  offering the IPO or the IPO involves huge sums, many investors will want to buy the shares of that company.  This is because shares of such companies have higher prospects of attractive returns, (1999: 303-323). Grinblatt and Hwang (1999: 393-421) further explained that investors are likely to place huge orders even before the IPO commences, and on the day of commencement, the share price is likely to sky rocket, leading to high volatility.  Campbell (2002: 905-939) says that other investors may decide to dump the stocks they currently own in favor of the ones being offered, in such large IPOs, leading to volatility in the companies that have been dumped.

Market Trading Volume

After an IPO, volume traded after the first day goes up usually due to efforts by the lead underwriter.  According to Cliff and Denis (2004: 2871-2901), in NASDAQ the lead underwriter, dominates the market after an IPO and within the first few days.  In fact, 60% of all trading volume is currently attributable to the lead underwriter, he explains.  After the following few months, the trading volume attributable to the lead underwriter falls to about 50% and continues gradually decreasing as the days go by.  They obtained this information after carrying out a research.  The major IPOs have a higher trading volume after trade that lasts for longer periods as compared to the minor IPOs.

They explain that the high trading volume can be attributed to the same shares being traded over and over again.  This can be described as flipping, and the shares are resold recurrently. Jay states that flipping represents a higher percentage of traded volume for minor IPOs as opposed to minor IPOs.  Institutional investors have been observed to flip greater percentages of stocks in IPOs, than retail investors (2000: 105-131). This can be attributed to over-subscription and subsequent efforts to ration the stocks.  This is explained by the fact that most institutions having large portfolios, consider holding smaller stakes in IPOs, not prudent.  They have two options; to either sell the available shares or buy some more.  Most opt for the first option since the latter is more expensive when initial returns are high (Lawrence and Paul 1999: 343-361), (Loughran (2004: 5-37).

There are two possibilities to the arbitrage. Here is an illustration of how arbitrage takes place is given by Cliff and Denis.  Assume ABC company is quoting shares at $3 and in derivatives market it is quoting at $3.1.  An arbitrager would make profit if he or she sold a future contract for ABC at $3.1 and simultaneously buy equal stocks from the cash market at $3.  This is the first step in arbitrage, they explain, that is sale of the contract and buying of the cash equivalent.  After a month or so, the arbitrager reverses his or her position and sells the cash market while buying a contract for the same.  This is the second phase of arbitrage. There are however risks involved with arbitrage and one of them is completing the transaction.  Guillermo and Michaely (2002: 1005-1047), elaborate that, unlike in the example where the price gain was high, in practice, the gains are very small and one can make profits, only when they arbitrage high volumes of stocks.  Some people however view the obstacles as theoretical, since in the real world, there are a number of stocks that are miss-priced.  This is due to reasons that include lack of adequate information to the market prior to the IPO.

When undertaking an IPO, the shares are sometimes under priced.  This is done to attract investors to shares that are either considered not liquid or are considered to be uncertain, when trading commences.  It makes the investors collect costly information and take part in the IPO.  They further add that when the under priced shares are sold through an IPO, especially for major IPOs, they are likely to be oversubscribed.  This creates high liquidity and subsequently high volatility since the prices of the stocks are likely to rise sharply. Aggarwal & Krigman rightly argues that, before the IPO, we have seen that there is the 'lockup period' where insiders of a company are restricted from selling their shares, for at least six months in order to allow for the market to develop on its own.  During this period, speculation by the investors concerning sale of stocks by insiders, after the expiration of this period, usually leads to cases of volatility among all shares being traded in the market.  This effect is mostly felt, when undertaking large IPOs (2002: 105-137). Some researchers believe that the higher the under pricing of the stocks is, the higher the liquidity in the market (Krigman 1999: 1015-1044).  There is also chance that once a company is under priced and attracts investors, the overall value of the company will appreciate, such as.  After the IPO, the market becomes relatively illiquid and some investors would want to sell the acquired shares during this period.

According to Keasler (2001: 241-228), the stability of an underwriter, in an IPO, is another factor that may cause change in liquidity.  This is especially so when the buyer is either not willing or not able to buy the stocks through other sources.  Keasler says that if the buyers have confidence with the underwriter's ability to provide support on price, when dealing with weak IPOs, the volatility will be low.  The underwriter may also make other traders to adopt a strategy of 'quote matching' depending on his or her support for the price.  This strategy involves traders quoting a price slightly above the price of the underwriter.  This may lead to high volatility due to the sudden changes in price of the stock.

There has been an increasing trend where the IPOs are getting more and scarcer in the developed countries, while increasing in emerging markets.  Raymond (2005: 67-79), attributes this to the credit crunch that developed economies are increasingly experiencing. He gives an example that the United States of America is currently experiencing a collapse of Wall Street.  According to research, the number of IPOs in emerging markets currently account for about 70% of all the global IPOs.  However, the number of IPOs in developed countries fell by 56%.

Potential Issues for Further Discussion

One of the issues involves the best time for carrying out Initial Public Offers.  This should include the factors that are considered when carrying out the IPOs and the effect that stock volatility has on the IPO, as opposed to vice verse.  Issues that make stakeholders in a company defer IPOs should also be addressed.  These issues should be discussed since they are closely related to how IPOs affect the market volatility.  The impact of IPOs on stock market volatility is closely related with the impact of stock market volatility on IPOs. The regulators should lengthen the restriction period beyond five days, according to Laura and Gordon (2001: 471-500).  This is the period in which the people who engaged in distribution should desist from carrying out activities that would excite the stock market and cause reactions.  The ideal time would be after the underwriter and issuer strike a deal regarding distribution.  This would reduce incidences of high volatility in the market. Mathewson goes on adding that it would also enable the investors make investment decisions, after analyzing the market information and thinking rationally (2004: 56). The regulators should strictly enforce the regulations of the stock exchange to prevent dishonest people from benefiting from unethical practices, according to Reena (2000: 1075-1103).  Such include, the artificial creation of the perception that, there is scarcity in the stocks being dealt in.

Another important factor to remember at this juncture is that Beta is a measure of the volatility of a security in relation to the general stock market, says Chan and Joseph (2002: 34-39).  Beta helps understand the risk that is attributable to stock of a particular company.  Beta can either be used to compare performance of the overall market to determine the overall market volatility, or compare performance of different market sectors in order to know the performance of the stock in relation to other stocks in the same sector.  Charles (1994: 32-48), says that a beta which is greater than one indicate that the stock has high volatility trends, while betas which are less than one indicate that the stock has lesser volatility trends. He further says that the stocks which have higher betas are the ones which are likely to have higher returns on the market, as compared to the stocks which have lower betas.  The use of betas in measuring stock volatility has weaknesses that include the lack of explanation of the volatility trends.  Betas do not adequately explain the different behavior that occurs between bull and bear markets with regards to stock volatility. Betas are also very useful in explaining the risk that is faced in the past but it does not explain the risk that is likely to be faced in the future.

There seems to significant other drawbacks associated with IPO offerings, as viewed by Rilter (2001: 3-27).  In a public company, he says that an IPO exposes the operations of the company to competitors, such as the salaries paid to employees, profits and sales of the company.  IPOs also dilute the ownership of the company and the current stockholders may lose the control of the company, he further contends.  Another drawback is the high cost that is involved in successfully carrying out an IPO, which may affect the future operations of the company.  Finally, he concludes by saying that the operations of a company may be affected by an IPO, due to emerging needs which should be addressed.  These include, changing the short term strategies due to the prevailing expectations and coping with the demands of the new stockholders, press and other stakeholders. The IPO usually involves a contract between the lead underwriter and the issuer for the issue of shares, Luccetti argues that the role of the underwriter is to find investors who are willing to purchase the shares.  The shares are then split between retail and institutional investors.  It is not uncommon for a group of investment banks to play the role of selling shares in major IPOs, he further explains.  In such scenarios, one bank acts as the leader and is called the lead underwriter (1999; 67).  The underwriters benefit from commissions earned from sale of the stocks, according to Irvine, in the case of multinationals, several underwriters operate depending on the legal position of the different markets of operation.  The IPOs need a law firm that is conversant with securities law to handle the legal aspects (2006: 23-37).

Moreover, the government should also ensure a stable political environment is maintained since any political instability, leads to panic among investors (Naranjo and Nimalendran 2000: 453-477).  This makes them start offloading their shares, and the share prices come down drastically, leading to high volatility in the stock markets.

 Over all, Initial Public Offers have played a vital role in financing companies activities.  They are especially useful when expanding the capital base of companies as well as acquisition of new assets or financing expansion programs of companies.  Initial Public Offers are especially useful to companies, since other sources of finance are increasingly becoming expensive, due to the increasing interest charges.  However, companies should be careful when undertaking IPOs since if unchecked; they have adverse effects to the companies undertaking them.  Such effects include exposure of the affairs of the company to competitors, as well as dilution of ownership of the company.  These shortfalls should be addressed by the stakeholders of the company and clearly defined in the IPO prospectus.

 Reference

1. Aggarwal, R., Krigman, L. 2002. Strategic IPO Under pricing, information momentum, and lockup expiration selling. Journal of Financial Economics. Blackwell Synergy. (105-137).
2. Allen, F., G. Faulhaber. 1999. Signaling by under pricing in the IPO market. Journal of financial economics. Elsevier, (303-323).
3. Bradley, D. B., Jordan, I. 2000. Venture capital and IPO lockup expiration: An empirical analysis. Journal of Financial Research. Blackwell Synergy, (465-493).
4. Campbell, J. 2002. Trading volume and serial correlation in stock returns. Quarterly Journal of Economics.(905-939).
5. Chan, L., Joseph, L. 2002. Robust measurement of beta risk. Journal of financial and quantitative analysis, (34-39).
6. Charles, M. 1994. Transactions, volume, and volatility. Review of financial studies, (32- 48).
7. Cliff, M., Denis, D. 2004. Do IPO firms purchase analyst coverage with under pricing? Journal of finance, (2871-2901).
8. Grinblatt, M., Hwang, C. 1999. Signaling and the pricing of new issues. Journal of finance. Blackwell Synergy, (393-421).
9. Guillermo, L., Michaely, R. 2002. Dynamic volume-return relation of individual stocks. Review of Financial Studies, (1005-1047).
10. Irvine, P. 2006. Brokerage commissions and institutional trading patterns. Babson College working paper, (23-37).
11. Jay, R. 2000. The seven percent solution. Journal of finance, (105-131).
12. Jonathan, M. (1997), The relation between price changes and trading volume: A survey. Journal of financial and quantitative analysis. (109-126).
13. Keasler, T. 2001. The underwriter’s early lock-up release: Empirical evidence. Journal of economics and finance, (241-228).
14. Krigman, L. 1999. The persistence of IPO mis pricing and the predictive power of flipping. Journal of finance. Elsevier,(1015-1044).
15. Lawrence M., Paul A. 1999. How investment bankers determine the offer price and allocation of new issues. Journal of financial economics. Blackwell Synergy, (343-361).
16. Laura, C., Gordon, H. 2001, The expiration of IPO share lockups. Journal of finance, (471- 500).
17. Loughran, T. 2004. Why has IPO under pricing changed over time? Financial management journal, (5-37).
18. Luccetti, A. 1999. SEC probes rates funds pay for commissions. Wall Street Journal, 67.
19. Mohan, N. J. 2000. Information content of lockup provisions in Initial Public Offerings. International review of economics and finance, (41-59).
20. Mathewson, J. 2004. U.S. SEC proposes new Initial Public Offering rules. Bloomberg News.
21. Naranjo, A., Nimalendran, M. 2000. Government intervention and adverse selection costs in foreign exchange markets. Review of financial studies, (453-477).
22. Raymond, P. H. 2005. Do institutions receive favorable allocations in IPOs with better long run returns? Journal of financial and quantitative analysis, (67-79).
23. Reena, A. 2000. Stabilization activities by underwriters after initial public offerings. Journal of finance, (1075-1103).
24. Richardson, M. 2003, DotCom mania: The rise and fall of Internet stock price. Journal of finance. 1113-1138.
25. Ritter, J. R. 2001. The long-run performance of Initial Public Offerings. Journal of finance, (3-27).
26. Torben G. 1996. Return volatility and trading volume: An information flow interpretation of stochastic volatility. Journal of Finance. (169-204).
27. Wang, J. 2005. Differential information and dynamic behavior of stock trading volume. Review of Financial Studies (919-972).
28. Weiss, K., William, J. 1995. Evidence on the strategic allocation of initial public offerings. Journal of financial economics, 4.

Don't let plagiarism ruin your grade

Run a free check or have your essay done for you

Check my essay Hire Writer