Liquidity shocks and SEO underpricing

We hypothesise that certain market conditions could lead to liquidity shocks that will consequently increase SEO underpricing (defined as the close-to-offer return). We propose three scenarios of market conditions, namely aggregate issues with large volume, large market declines and market volatility. Using a sample of about 5,000 seasoned equity offerings from 1987 to 2009, we found that market volatility is significantly and positively related to SEO underpricing after controlling for other factors. We employed an estimation method proposed by Chambers and Dimson (2009) to examine the behaviour of SEO underpricing over our sample period from 1987 to 2009. We found that after controlling for changing risk composition, price practice, market conditions and the influence of underwriter reputation and analyst coverage, there was still an upward shift in SEO underpricing over the sample period, and the pattern cannot be fully explained by the practice of setting offer prices at lower integers. We borrowed the investment banking power hypothesis from the literature and argued that the upward shift of SEO underpricing over the sample period could be explained by the increase of investment banking power. As the industry structure of underwriting transfers from a competitive market to an oligopoly market, banks use non-price dimensions to gain market power and consequently increase SEO underpricing