Investment Banking

Chapter 3: Price Setting Mechanisms

Thach H. Pham1

February 20, 2024

1
thach.ph@ou.edu.vn
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Outline

1 The Book-Building Approach

2 A Simple Model

3 Auctions

4 The Dark Side of Book-Building

Key Concepts & Skills

Book-building
Auctions
Pathology of book-building

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Topic

1 The Book-Building Approach

2 A Simple Model

3 Auctions

4 The Dark Side of Book-Building

The Process

The company’s management: presentation

The book-runner: collect non-binding bids
The sale forces (syndicate banks): solicit orders
Investors: submit, revise, withdraw orders
The book-runner negotiate with the issuer the price

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Types of Bid

Strike bid: request for shares (or amount of money) regardless

of the issue price.
Limit: specifies the maximum price that the bidder is willing to
pay for the shares.
Step bid: the bidder submits a demand schedule as a step
function.

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The Book

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The IPO

Key variables: the price and information (hard + soft)

Hard info.: insights about the firm (numbers)
Soft info.: opinions, ideas, rumors, economic projections,
statements of management’s future plan, and market
commentary (text)

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Price Setting

The book shows the market demand for the issue

Incentive to understate their interest in an offering
Solution: strategic pricing and allocation policy
At the closing of the book, bankers analyze the demand curve
(quantity and quality)

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Price Setting (contd.)

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Topic

1 The Book-Building Approach

2 A Simple Model

3 Auctions

4 The Dark Side of Book-Building

IPO Info.

Issue: 100 shares (S)

VH : €11
VL : €9
DI : 100 shares
DR : 70 shares
Assumptions: equal probability, the issuer and its bank know the
true value & the true value of the issuing firm becomes clear at
the closing of the offering.

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Fixed Price

Institutional Investors
True value = VH = €11
True value = VL = €9

Retail Investors:
[ ]
DR
(VH − P)DR = (P − VL )DR
DI + DR
What is the break-even point?
True value = VH = €11
True value = VL = €9

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Book-Building

AH (VH − PH ) > AL (VH − PL )

{
AH =S
Let :
AL = S − DR
AL
→ PH < VH − (VH − VL )
AH
→ E[P] = pH VH + pL VL

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The Empirical Evidence

Terminologies
Bidder’s rationing (raw measure): the ratio of shares allocated
to the shares requested.
Oversubscription: the ratio of total demand to total supply
The percentage bid: the bid quantity over the total demand for
shares in the issue
The percentage allocation: the quantity allocated to a bidder
over the total supply in the issue.

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The Empirical Evidence (contd.)

Normalized Measurement
A normalized measure of rationing: the ratio of percentage
allocation to percentage bid
Normalized Rationing = Raw Rationing × Oversubscription
Normalized rationing = 1: allocations are on a pro-rata basis
Normalized rationing > 1: bidder is favored
Normalized rationing < 1: bidder is penalized

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The Empirical Evidence (contd.)

Raw and Nomalized Rationing

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The Empirical Evidence (contd.)
The Impact of Factors on The Nomalized Rationing

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Topic

1 The Book-Building Approach

2 A Simple Model

3 Auctions

4 The Dark Side of Book-Building

Types of Auctions

Uniform-Price Auctions
Bidders pay the same price (market-clearing)
Clearing price: the highest price for which sufficient bids at
decreasing prices cover the shares being offered
Bid > clearing price: whole shares
Bid < clearing price: pro-rata allocation of shares

Discrimatory
Pay what you bid

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Types of Auctions (contd.)

Auction Order Book

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Types of Auctions (contd.)

Advantages/ Disadvantages
Precise price
Highly uncertain in term of subscriptions and pricing accuracy
(over/underpricing)

The Winner’s Curse

I won, but I wish I hadn’t

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Types of Auctions (contd.)

The Winner’s Curse (contd.)

Solution: reduce the bids to offset the upward bias
Bidders need to know the participants & the degree of
information asymmetry

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Types of Auctions (contd.)

The Free Rider Problem

Incentive to submit high bids without actually valuing the issue
As a result a sufficiently high number of free riders will produce
overpricing
Solution: the issuer and its investment bank negotiate with
market authority a maximum price, after the auction is closed.

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Types of Auctions (contd.)

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Topic

1 The Book-Building Approach

2 A Simple Model

3 Auctions

4 The Dark Side of Book-Building

Underpricing

The reward to institutional investors consists in larger

allocations of underpriced shares
A compensation to investors for revealing their heavy demand
Underpriced shares: a bribe at the expense of the issuer

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