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Questions and Answers
What is the tendency of extreme past losers in the market according to the winner-loser effect?
What is the primary reason behind the winner-loser effect according to behavioral finance?
What is the traditional interpretation of the winner-loser effect?
What is the tendency of recent winners in the market according to the momentum effect?
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What is the term for the phenomenon where the percentage change in market price in response to an event is too small?
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What is the opposite of underreaction in the market?
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What occurs when a firm announces earnings that exceed the consensus analyst forecast?
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What is the process of exploiting mispricing in finance?
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What is characterized by demand for new issues being relatively high?
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What results when the offer price is too low, resulting in a large first-day price pop?
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What refers to the phenomenon of stock prices adjusting slowly to earnings surprises?
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What refers to new issues earning lower returns than comparable stocks?
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What should a financial executive of a privately held firm consider doing when faced with a hot issue market?
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Who plays an important role in determining the IPO offer price?
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What is the implication of initial underpricing in IPOs?
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What is a potential explanation for long-term underperformance according to proponents of market efficiency?
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What is the traditional efficient-market based advice to managers regarding market timing?
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What is the purpose of the pricing meeting between the firm's executives and the underwriters?
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What does Exhibit 5.2 display?
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What happens to the returns of issuing firms relative to comparable firms six months after the new issue?
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What is the estimated annual underperformance of IPOs over a five-year horizon?
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What is the potential consequence of going IPO in a hot issue market and paying for all-star analyst coverage?
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What corresponds to maximizing long-term value, according to the conventional approach?
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What is the dilemma faced by executives regarding IPOs?
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What assumption is required for managers to compute NPV correctly?
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What should discount rates for the long-term be based on according to the text?
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What has been observed in managers' forecasts according to the text?
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What is the discussion related to in the provided text?
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What is the source of the additional reading provided?
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Study Notes
Long-term Reversals: Winner-Loser Effect
- Extreme past losers tend to outperform the market, while extreme past winners tend to underperform the market.
- Behaviorists attribute this phenomenon to representativeness, which leads to extrapolation bias in respect to prior earnings.
- Investors overreact to stocks that have been past losers, causing them to become undervalued, and overreact to past winners, causing them to become overvalued.
Momentum: Short-Term Continuation
- Recent losers tend to underperform the market, while recent winners tend to outperform the market.
- Underreaction and overreaction occur due to the percentage change in market price being too small or too large in response to an event.
Post-Earnings-Announcement Drift
- Analysts forecast earnings, and when a firm's earnings exceed or fall below the consensus analyst forecast, it is a positive or negative surprise.
- Empirically, stock prices do not adjust immediately to earnings surprises, instead exhibiting drift.
Arbitrage
- Arbitrage is the process of exploiting mispricing, buying low and selling high.
- The efficient market perspective relies on arbitrage, where smart investors quickly take advantage of mispricing caused by irrational investors, rendering the mispricing small and temporary.
To IPO or Not to IPO?
- IPO decisions take place against the backdrop of three phenomena: hot issue market, initial underpricing, and long-term underperformance.
- Hot issue market refers to a high demand for new issues.
- Initial underpricing occurs when the offer price is too low, resulting in a large first-day price pop.
- Long-term underperformance occurs when new issues earn lower returns than stocks with comparable characteristics.
IPO Decision Dilemma
- Executives face a dilemma: maximizing market value in the short-term by going IPO in a hot issue market and paying for all-star analyst coverage through initial underpricing, but potentially exploiting excessive optimism, which may lead to long-term underperformance.
- Managers should consider maximizing long-term value, which corresponds to the conventional approach based on NPV, and discount rates used for the long-term should be based on the single-factor CAPM approach.
Forecasting Biases
- Managers' forecasts of cash flow, the market risk premium, and risk are subject to systematic bias.
- Biased forecasts can affect the accuracy of NPV calculations.
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Description
In a hot issue market, should a privately held firm move up its plans to go public and take advantage of the market conditions? This quiz assesses your understanding of IPO decisions and behavioral finance concepts.
