Asymmetric information is an important reason for why underpricing exists in the IPO process

Question

BlackTom AI · Accepted Answer

When examining the statement, we start by unpacking the concept of asymmetric information in the IPO context. 
Option 1: True. The idea is that underwriters often have more information about a firm’s true value than new investors. This information gap can lead underpricing as a mechanism to attract investors who might otherwise demand a higher return for the risk of the unknown true value. Underpricing can thus serve as a signal and a form of compensation to reduce adverse selection risk for the underwriter. 
Option 2: False. If one assumes markets are perfectly informed, asymmetric information would not exist, and underpricing would not be needed as a corrective device. However, empirical and theoretical work on IPOs emphasizes information gaps between issuers, underwriters, and investors, making this option inconsistent with observed practice. 
Option 3: Either is possible. While some markets or periods might exhibit weaker information gaps, the standard IPO literature argues that asymmetric information is a persistent driver of underpricing. Saying either is possible would ignore the established role of information asymmetry as a fundamental rationale for underpricing. 
In summary, the core reasoning is that asymmetric information creates signaling dynamics and risk premia for uninformed investors, which underwriters use to justify and implement initial pricing promotions. The other options overlook the central role of information gaps or overstate ambiguity about their existence.

SP25-BL-BUS-F402-5344 Raising Capital and IPOs

Asymmetric information is an important reason for why underpricing exists in the IPO process

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Asymmetric information is an important reason for why underpricing exists in the IPO process

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