Finance
One method utilized by companies to obtain the long-term capital necessary to run and grow their
businesses is by providing the general public with the option to purchase stocks. The company’s first sale
of stock is known as the initial public offering (IPO). When a company first offers the IPO, stocks are, on
average, underpriced.
� Discuss the implications of such underpricing to established theories of market efficiency.
� Explain the role market efficiency might play in the underpricing theories presented by Loughran and
Ritter.
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Section 1
Initial public offering (IPO) is mostly underpriced or below the market value. Usually,
IPOs are in most cases underpriced because of issues relating to liquidity and the uncertainty on
the level at which the stock is expected to trade. Low liquidity results to low uncertainty; hence,
the need to under price to compensate investors for taking the risk. A company may be aware of
the value of shares; however, the investor may not be aware. Therefore, the company must offer
a lower price with the intent of encouraging investors. On the other hand, if IPO is offered at a
higher price, investors are likely to reject. As such, the company is forced to give low prices to
attract as many investors as possible (Gondat-Larralde & James, 2008).
IPOs are less understood by some investors. In fact, there are two types of investors, the
informed and the uniformed. The informed investors are knowledgeable about the true value of
shares while the uniformed only invest randomly without the knowledge on the value of shares.
Usually, the price of fluctuates by the changes in demand as the stock is held constant. The
demand is separated in two: informed and uniformed investor demand. If companies had IPOs
that reflect their true value, then the uninformed investors would break or lose money as the
informed investors would only invest in good IPOs. This would crowd out uninformed investors
and be the only people turning profits. The law allows investment banks to allocate shares of
oversubscribed that crowds out uninformed investors (Loughran & Ritter, 2004).
Ritter and Loughran stipulate that riskier IPOs are underpriced as compared to less risky
ones. This attracts many investors as opposed to overpriced IPOs that discouraged informed
investors. Further, it has been observed that IPOs stocks over the long seem to underperform the
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market. The long term underperformance is an anomaly that shows inefficient market hypothesis
with inherent challenges. There is an argument that IPOs have a track record of earnings by the
time they go public. The participants fail to realize that earnings growth reverts the stick prices
before going public are quite high. It is claimed that SEOs have good returns three years before
the issue. The past earnings are then corrected over time slowly (Schwert, 2003). To increase
market efficiency, the uninformed investors should reduce uncertainties and gain the necessary
information and increase market efficiencies. Analyzing of information can help traders to make
informed decisions about IPOs.
Market efficiency refers to the availability of relevant information on stock prices is
reflected. This view stipulates that it is not possible for investors to outperform the market since
all the information is in stock prices. The concept of efficient markets relies majorly on the ideals
of random walk that stipulates that price changes of today are independent of the past (Fama,
1998). This means that the flow of information should be uninterrupted and should not incur any
cost. The information should reflect on the prices immediately. The price of tomorrow will
change in anticipation to tomorrow’s news, which is unpredictable. Therefore, the prices of
tomorrow are also unpredictable and random. This same view claims that efficient markets fails
to allow investors to earn high profits without taking high risks.
It is arguable that market efficiency is the function of information cost. Information determines
the distribution of IPOs. Thus, the analysis of information market is critical to understand
anomalies that might emerge in the market.
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References
Fama, E. F. (1998). Market efficiency, long-term returns, and behavioral finance. Journal of
financial economics, 49(3), 283-306.
Gondat-Larralde, C., & James, K. (2008). IPO pricing and share allocation: The importance of
being ignorant. Journal of Finance, 63(1), 449–478. Retrieved from Business Source
Premier database.
Loughran, T., & Ritter, J. (2004). Why has IPO underpricing changed over time? Financial
Management (Blackwell Publishing Limited, Autumn), 33(3), 5–37. Retrieved from
Business Source Premier database.
Schwert, G. W. (2003). Anomalies and market efficiency. Handbook of the Economics of
Finance, 1, 939-974.
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Section 2
International finance is a body that deals with monetary economics at international levels.
It is a body of financial system that protects the framework of finance institutions and legal
agreements. The evolution of international finance has led to the development of central bank
and other institutions such as multilateral agreements. The central bank is the major player in
international finance (Ocampo, 2007). It is charged with the role of currency exchange between
various countries. It determines the value of differing currencies in differing countries in relation
to another. The foreign exchange rate is open and is determined by many factors. Buyers and
sellers must know the value of currency of the countries they are trading with in order to
determine the price and exchange rates. The international traders must also understand the
fluctuations in the exchange rates.
International finance determines the value of currency for each country depending on
factors. The currency for a particular country has more value if its demand is greater than the
supply. On the other hand, when the demand is less that supply, the currency becomes weaker.
This does not mean that people will not value that money anymore; rather, they prefer keeping
their wealth in another form. The international finance helps people and corporations to
determine when to trade and make more profits at international levels depending on the value of
currency of the trading countries. The transaction demand for money leads to increased demand
for stronger currency. This demand for transaction is determined by the country’s level of GDP,
employment and business activities. The lesser the employment level, the less the people will get
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involved in trade and transactions; hence, weaker currency. Other factor that the international
finance is charged with is the adjusting of interest rates. The higher the interest rates, the more
the demand for currency and vice versa. For carrier companies, information on exchange rates is
crucial in carrying out businesses. Therefore, such companies need to seek the expertise of
international finance in order to maximize profits and determine when to trade and when to hold
on (Greuning, Scott & Terblanche, 2011).
Even though the exchange rate is crucial in financial market of international
communities, this does not mean that corporate finance is all about exchange rates. The basic
domestic corporate finance is crucial in the foreign exchange. Likewise, international
corporations are greatly influenced by cultural, political, and environmental regulations and
changes (Madura, 2011).
Exchange rate is a process in which the pricing system and currency exchange takes place
at international levels. Exchange rate changes over time depending on the changes in domestic
and international market. Corporations at international levels use critical information availed in
the foreign exchange market to help in capital budgeting and making critical decisions necessary
for future growth. The managers in the financial sector accept decisive factor of market
efficiency and act in the interests of all shareholders. In cases where the exchange rate matters
most, international finance corporations purchase power parity to balance the risks inherent in
exchange rates and capital budgeting.
It is true that international finance deals with currency exchange; however, there are
many more roles than that. It is responsible for advising international traders in order to
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determine when it is best to trade (Sercu, 2009). As such, international finance is not just
exchange rate.
References
Greuning, H. ., Scott, D., & Terblanche, S. (2011). International financial reporting standards:
A practical guide. Washington, D.C: World Bank.
Madura, J. (2011). International Financial Management. Florence, KY: Cengage Learning, Inc.
Ocampo, G. J. A. (2007). International finance and development. New York, NY [u.a.: Zed
Books.
Sercu, P. (2009). International finance: Theory into practice. Princeton, N.J: Princeton
University Press.
