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Abstract

The purpose of this paper is to analyze a new issue process in a model that focuses on the contractual relationship between an issuing firm and its investment banker, when the latter is assumed to have superior information regarding the market demand for the new securities. A “firm commitment” contract induces first-best choices of marketing effort and offer price by the banker, but is shown to be suboptimal for the issuer when the information asymmetry exists prior to contracting. The issuer's selection of a second-best underwriting contract is shown to result, under certain conditions, in the offer price set below the first best level. This “underpricing” result is explicitly explained and related to the empirical literature on underpricing. Finally, it is shown that, under a reasonable condition, the issuer does not lose value by delegating the pricing decision to the better informed investment banker.

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Optimal Underwriting Contracts and Underpricing of New Issues

Abstract

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