Price Stabilization as a Bonding Mechanism in New Equity Issues

Examines the use of price stabilization and penalty bid provisions in primary equity markets. The model created in this analysis is based on the assumption that an underwriter represents the firm, the firm is issuing a fixed claim on its future cash flows, and there are two distinct pools of investors: regular and retail investors. Regular investors are likely to understate their interest in an investment, as they know that the underwriter bases the offer price on this interest. The underwriter must try to balance the somewhat conflicting goals of maximizing expected proceeds with gaining truthful indications of interest. This analysis begins by deriving the optimal price and allocation schedule while assuming that potential investors can obtain credible pre-market information. The analysis then moves to the situation in which investors cannot obtain information on the pre-market conditions. An overstatement of pre-market interest by an issuing firm increases investor expectations and, in turn, the offer price. Underwriters who agree to price stabilization are unlikely to overstate investor interest prior to fixing the offer price for a new issue. Allowing underwriters to utilize penalty bid systems provides for further efficiency gains. The primary equity market is made more efficient when underwriters utilize price stabilization as a bonding mechanism. (SRD)