Downside Risk and Underpricing of IPOs: Evidence from Put Back Options Revisited

The underpricing effect of including put back options (PBs) in initial public offerings (IPOs) has been so ambiguous that the regulation of PBs seems little related to the underpricing. The little relationship is inconsistent with the hypothesis of price support which states that the underwriters of the IPOs exposed to high downside risk lower the offer prices. This paper models the effect of PBs on reinvestment opportunities using the model in Lee and Joh (2007). The paper also introduces a measure of downside risk defined as the return of the modified value over the offer price, which is an increasing function of over-theperiod variance, and applies the measure to examine the positive relationship between downside risk and underpricing. Data from IPOs that include PBs shows that the average downside risk, measured as the return of the value from the modeling over the offer price, is approximately 20 percent of the average underpricing at the first secondary market date. The underpricing during the guarantee period is strongly associated with the downside risk. An increase in the downside risk significantly increases underpricing, a finding that contrasts with previous evidence (Lee and Joh, 2007; Shin, 2010), suggesting that the hypothesis works for the situation in Korea.