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Essays on the Equilibrium Valuation of IPOs and Bonds by Kehong Wen B.S.(University of Science and Technology of China) 1987 Ph.D. (The University of Texas at Austin) 1993 A dissertation submitted in partial satisfaction of the requirements for the degree of Doctor of Philosophy in Business Administration in the GRADUATE DIVISION of the UNIVERSITY of CALIFORNIA at BERKELEY Committee in charge: Professor Mark Rubinstein, Chair Professor Henry Cao, Co-Chair Professor Nils Hakansson Professor Roger Craine May 2000 UMI Number: 9981117 Copyright 2000 by Wen, Kehong All rights reserved ______________________________________________________________ UMI Microform 9981117 Copyright 2000 by Bell & Howell Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. _______________________________________________________________ Bell & Howell Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 The dissertation of Kehong Wen is approved: Chair Date Date Date Date University of California at Berkeley May 2000 Essays on the Equilibrium Valuation of IPOs and Bonds Copyright May 2000 by Kehong Wen 1 Abstract Essays on the Equilibrium Valuation of IPOs and Bonds by Kehong Wen Doctor of Philosophy in Business Administration University of California at Berkeley Professor Mark Rubinstein, Chair Chapter 1 of this dissertation provides rational explanations for the IPO underperformance puzzle. IPO underperformance is shown to arise in three equilibrium models with investor heterogeneity and participation restrictions. The models also help explain why IPO under- performance is concentrated in small stocks and why the average IPO return can be below the risk-free rate. In these models, IPO residual risk acts as a source of systematic risk. Schumpeterian creative destruction plays a key role in one of the models. This model is extended into a dynamic setting in Chapter 2 to demonstrate that persistent after-market underperformance is consistent with a rational expectations equilibrium. Building on the dynamic extension, a uni…ed framework is o¤ered in Chapter 3 to address all three IPO pricing puzzles. Many testable implications are derived and presented in detail to facilitate future empirical work. Chapter 4 investigates the general equilibrium implications of introducing new 2 industries into the economy. It …rst establishes that the equilibrium of an N-industry pure- exchange economy supports an N-factor Vasicek term structure of interest rates. It then shows that industry characteristics enter as direct determinants of the yield curve, the term premium, the forward premium, and the stock premium. Depending on the nature of industry heterogeneity, the term structure of interest rates and the stock premium can have qualitatively di¤erent dynamics. Depending on how industries interact, the market- price-of-risk vector may admit di¤erent signs for its components. Consequently, risky assets representing high impact industries can have negative return premia over bonds. This helps explain why new industries may appear over-valued at times. Professor Mark Rubinstein Dissertation Committee Chair iii To my wife, Yunfang Lu, and my daughter, Yanming Melinda Wen, the stars in my life. iv Contents List of Figures vi List of Tables vii 1 A Rational Approach to IPO Underperformance 1 1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.2 Relation to Other Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1.3 Model Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1.4 “Creative Destruction” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.5 Heterogeneous Belief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 1.6 Preference for Skewness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 1.7 Long-run Underperformance: Benchmarks and Sources . . . . . . . . . . . . 33 2 A Dynamic After-market Model 36 2.1 Model Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 2.2 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 2.3 Testable Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 2.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 3 A Uni…ed Approach to the Three IPO Puzzles 48 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 3.2 Underpricing and Hot-issue Market . . . . . . . . . . . . . . . . . . . . . . . 52 3.3 Testable Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 3.4 Relation to Other Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.4.1 Underpricing Literature . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.4.2 Hot-issue Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 3.4.3 Relation between Underperformance and Underpricing . . . . . . . . 68 3.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 4 Equilibrium Valuation in a Vasicek Economy with Heterogeneous Indus- tries 70 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 v 4.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 4.3 The One-factor Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . . . 79 4.4 The Multi-factor Vasicek Term Structure . . . . . . . . . . . . . . . . . . . 85 4.4.1 The Two-factor Case . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 4.4.2 Equilibrium Security Prices . . . . . . . . . . . . . . . . . . . . . . . 88 4.4.3 Properties of the Two-factor Term Structure . . . . . . . . . . . . . 90 4.4.4 The N-factor Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 4.5 Stock-fund Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 4.6 Comparative Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 4.6.1 Yield Curve Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . 106 4.6.2 Term Premium and Stock Premium . . . . . . . . . . . . . . . . . . 107 4.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 5 References 112 A Proofs 118 [...]... motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.” The competition thus created is “competition which commands a decisive cost or quality advantage and which strikes not at the margins of the pro…ts and the outputs of the existing …rms but at their very foundations and. .. topple the domination of Microsoft in the software market for personal computers and network computers Amazon.com, the pioneer of online retailing, imposed intense competitive pressure on traditional “bricks -and- mortar” business models, with its enormous cost advantage and superior customer service, both enabled by the proliferation of the internet E*Trade, a pioneer of online brokerage, has not only... existing securities) of IPOs IPO residual risk acts as a source of systematic risk and is priced in equilibrium From the point of view that innovation is the source of sustained economic growth and economic development (Schumpeter 1934, 1942), new enterprises represent the future of the economic system Therefore, the risk associated with the emergence of new industries becomes part of the economy-wide systematic... dynamic extension of the static model with heterogeneous endowments, so that the intertemporal aspect of IPO after-market performance under the environment of changing participation restrictions can be analyzed I obtain closed-form solution for the dynamic rational-expectations equilibrium The equilibrium concept used is the Radner (1972) equilibrium of plans, prices, and price expectations Using the model... will be shown in Sections 1.4-1.6, the inverse of the size of the IPO stock appears in the coe¢cients of factors that determine IPO expected return Hence, size matters in cross-sectional regressions, but not as a risk factor And since 8 there is a negative sign in front of the coe¢cients, the smaller the size, the more severe the underperformance, other things being equal The rest of the paper is organized... the possible erosion of future labor income, A is willing to pay an extra price for the IPO If there is no endowment di¤erence, i.e ´ = 0; A and B simply divide up the shares of the IPO The di¤erence of the optimal holdings of asset 2 between A and B is exactly ´, the di¤erence in units of endowment between the two agents The hedging demand term can be regarded as a measure of the “impactness” of the. .. direction: from the new enterprise to existing knowledge This captures the spirit of Schumpeter’s discussion quoted above The correlation, which can be any number between ¡1 and +1, between payo¤s aM +N and bM ¡N, is determined by the coe¢cients a and b: The magnitude of ´ measures the degree of erosion of old knowledge Remark 2 This assumption and the assumption about the IPO payo¤ (aM + N) recognize the crucial... They are also endowed with non-tradeable, uncertain incomes fei gi2I that are received at the end of the period Participation Restriction There is no restriction on investment in asset 1 The total number of shares of asset 1 is normalized to one There is a lower bound l 6 0 for shorting asset 2 It is de…ned as the negative of the ratio of the total number of shares available for short sale over the. .. three explanations, which in one form or another rely on investor naivete, the explanation o¤ered in this chapter is based on investor rationality 1.3 Model Setup This section develops three one-period models, focusing on the equilibrium pricing impacts of the short-sale constraint and limited share supply when investors di¤er in their endowments, beliefs, and preferences The basic setup for these models... model is further developed into a multiperiod rational expectations model in Sections 2.1-2.2 Section 2.3 presents a number of testable implications to facilitate future empirical work Section 2.4 concludes and discusses limitations and possible future extensions of the static and dynamic models developed in Chapter 1 and Chapter 2 All formal proofs are collected in the Appendix 1.2 Relation to Other Work . Essays on the Equilibrium Valuation of IPOs and Bonds by Kehong Wen B.S.(University of Science and Technology of China) 1987 Ph.D. (The University of. Date Date Date Date University of California at Berkeley May 2000 Essays on the Equilibrium Valuation of IPOs and Bonds Copyright May 2000 by Kehong Wen 1 Abstract Essays on the Equilibrium