The Underpricing and Excess Returns of Initial Public Offerings in Taiwan Based on the Noisy Trading: A Stochastic Frontier Model

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Abstract
It is well known that initial public offerings (IPOs) are typically offered at prices lower than the transaction prices in the early aftermarket. However, the gap between the offer price and the aftermarket transaction price may be attributed to the underpricing of IPOs or the noisy trading activities in the early aftermarket. In this paper, we employ a stochastic frontier model to measure the fair offer price of an IPO and then measure the deliberate underpricing of the IPO and the market misvaluation based on the estimated fair offer price. Our results show that IPOs are deliberately underpriced. However, the extent of underpricing is not related to the hotness of the market. Instead, the extent of noisy trading leading to the market transaction price explains the excess return of IPOs, which is related to the hotness of the market. Hence, we conclude that IPO initial returns mostly result from the noisy trading activities instead of the deliberate underpricing of IPOs.

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