Prospect Theory and IPO Returns in China

Chinese IPOs offer investors two potential lottery-like gains. One is huge first day returns as Chinese issuers leave more money on the table than other issuers and the other is that a particular IPO may go on to become the next Alibaba in the long run. Using a sample of 862 book-built Chinese IPOs 2006-2012,this paper finds a significantly positive relationship between expected skewness and two direct measures of retail investor demand. It also establishes a positive relationship between expected skewness and first-day returns that are mainly driven by the sentiment of retail investors. A one-standard-deviation increase in expected skewness of an IPO stock leads to an increase of 4.7-9.3 percentage points in the first-day return. It also finds robust evidence of a negative relationship between expected skewness and long-term abnormal returns as retail investors sell. A one-standard-deviation increase in expected skewness predicts a decrease of 22-33 percentage points in the 36-month post-IPO abnormal return.Taken together, these findings suggest that skewness preference exerts asignificant influence on post-IPO returns through retail demand in China