Regulatory Environment, Changing Incentives, and IPO Underpricing in the Korean Stock Market*

Abstract

I examine the importance of price support regulation in explaining IPO underpricing in the Korean stock market from 2001 through 2007. In contrast to the US practice where price support is provided effectively at the cost of the issuing firms, the price support in Korea resulted in direct costs to the underwriters. I construct a simple model to capture this feature of the regulation where IPO prices are determined through the interaction of the maximizing behaviors of underwriters and issuers. In the model, three variables, namely, the expected post-IPO price volatility, size of newly issued shares, and size of tradable shares, are specified to affect the opportunity costs of underpricing. When combined with the regulatory regime change in 2003, which lightened underwriters' obligations towards price support, the model implies that the magnitudes of the relationships between the three variables and underpricing have decreased since 2003. I test the hypotheses and find supportive empirical results: the relationship of underpricing with the expected price volatility has changed from positive to insignificant; those with sizes of newly issued and tradable shares from insignificant to negative. The findings contrast with existing Korean studies that do not find any evidence that price support regulation decreased the opportunity cost of underpricing for underwriters. The results also illustrate a more general point that to fully understand underpricing in a given stock market, it is crucial to take into account the regulatory environment that systematically influences agents' incentives to control or generate underpricing.

How Bookbuilding Information Affects Korean IPO Pricing Processes

“…We find that TRADABLE, a proxy of the proportion of liquidity investors, is negatively related to IPO initial returns. This finding is consistent with the study by Shin () on Korean IPOs listed in the KOSDAQ over the period October 2003 to May 2007. He attributes the negative predictability of TRADABLE to the regulatory change in August 2003, in which the put‐back option was allowed for retail investors alone.…”

“…This finding may be explained by the fact that the KRX‐listed IPOs increase by 8% between the two subsample periods, and thus investors are less likely to overreact to KRX listings as membership becomes less scarce in the post‐change period. Finally, the disappearing predictability of TRADABLE in the post‐change period supports the conclusion of Shin (), since the put‐back option was completely abolished by the 2007 regulatory change.…”

“…A similar specification is found in Shin () for Korean IPOs. Throughout this paper, we refer to the regression equation as the backbone model, since no premarket auctioning information is explicitly accounted for.…”

“…In August 2003, this obligation was abolished and replaced with the put‐back option, in which retail investors are granted an option to resell IPO shares to underwriters at 90% of the offer price in the month following the offering. According to Shin (), this change lowers the floatation costs of underwriters and in turn weakens the underwriter's incentive to sell undervalued shares.…”

“…This is because the unsubscribed shares are conventionally transmitted to institutional investors. Shin () finds that the allocation to institutional investors varies little and is around 65% for Korean IPOs in the period 2001–2007.…”