Anatomy of Initial Public Offerings of Common Stock

ABSTRACT Initial public offerings of common stocks (IPOs) are typically underpriced. In this paper, the author develops and tests the hypothesis that underpricing serves as a form of insurance against legal liability and the associated damages to the reputations of investment bankers. The empirical results based on samples of IPOs that were brought to the market before and after the Securities Act of 1933 provide considerable support for the implicit insurance hypothesis. Specifically, gross underpricing and market segmentation between prestigious and fringe investment bankers in originating unseasoned new issues appear to be peculiar to the post‐1933 era.