3.8Stock Returns Associated with ipOs of Common Equity

We noted previously that, on average, IPOs are underpriced. For example, Netscape’s

stock was issued at $28 a share and closed the first day at $58.25, which suggests that

the underwriter underpriced the shares by 108 percent [($58.25 $28.00)/$28.00],

which is an extreme example of underpricing.

Ipo Underpricing of u.S. Stocks

The cost associated with the underpricing of new issues is a major cost associated with

going public and has been researched extensively. Researchers generally measure

underpricing as the average initial returns measured over the first trading day (the per-

centage increase from the offering price to the first closing price). Exhibit 3.4 provides

the average initial returns for the last four decades of the last century. These initial

returns averaged about 17% during this time period but were somewhat larger in the

latter half of the 1990s.

Estimates of International IPO Underpricing

Exhibit 3.5 reveals that IPOs are underpriced all over the world. The magnitude of the

underpricing is especially large in some of the less developed capital markets, with

Malaysia, Brazil, and South Korea exhibiting the greatest degree of underpricing.

Although large differences appear in the amount of underpricing in developed capital

markets relative to the less developed ones, the difference between the amount of under-

pricing in the United Kingdom, where fixed-price offers dominate, and the United

States, where book building dominates, is not particularly large.

What Are the Long-Term Returns of IPOs?

Aseries of papers_Ritter (1991), Loughran, Ritter, and Rydqvist (1994), and Aggarwal

and Rivoli (1990)_have shown that the long-term return to investing in IPOs is surpris-

ingly low. Examining the shareholder return to owning a portfolio of IPOs for up to five

years after the companies went public, these studies find annual returns to be in the range

¹⁴This

discussion is based on recent papers by Sherman (2001) and Ljungvist, Jenkinson, and

Wilhelm (2000).

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EXHIBIT3.5Average Initial Returns of IPOs in 25 Countries

	Average Initial
Country	Return (percent)	Period Studied	Sample Size

Malaysia	80%	1980–1991	132
Brazil	79	1979–1990	62
Korea	78	1980–1990	347
Thailand	58	1988–1989	32
Portugal	54	1986–1987	62
Taiwan	45	1971–1990	168
Sweden	39	1970–1991	213
Switzerland	36	1983–1989	42
Spain	35	1985–1990	71
Mexico	33	1987–1990	37
Japan	33	1970–1991	472
New Zealand	29	1979–1991	149
Italy	27	1985–1991	75
Singapore	27	1973–1987	66
Hong Kong	18	1980–1990	80
Chile	16	1982–1990	19
United States	15	1960–1992	10,626
United Kingdom	12	1959–1990	2,133
Australia	12	1976–1989	266
Germany	11	1978–1992	170
Belgium	10	1984–1990	28
Finland	10	1984–1992	85
Netherlands	7	1982–1991	72
Canada	5	1971–1992	258
France	4	1983–1992	187

Source:Reprinted from Pacific Basin Finance Journal,1994. No. 2. Loughran, Ritter, and Rydqvist, Table 1,

pp.165–199, ©1994 with kind permission of Elsevier Science-NL, Sara Burgerhartstreet 25, 1055 KVAmsterdam.

The Netherlands.

of 3 percent to 5 percent, far below other benchmark returns. Given these returns, the ter-

minal value of an IPO portfolio after five years is only 70 percent to 80 percent of the

value of a portfolio that invested in all NYSE and AMEX stocks or a portfolio that invested

in the S&P500 Index. The evidence reviewed in Loughran, Ritter, and Rydqvist (1994)

shows that investors in Brazil, Finland, Germany, and the United Kingdom would have

been just as disappointed with their investments in IPOs as investors in the United States.

More recent evidence suggests, however, that when the performance of IPOs is

measured relative to comparison stocks with equivalent size- and book-to-market ratios,

the underperformance of IPOs disappears (see Brav and Gompers [1997] and Brav,

Geczy, and Gompers [2000]). Most IPOs can be categorized as small growth stocks,

and these stocks have historically had extremely low returns. IPOs do quite poorly in

the five years subsequent to their issuance, but similar small growth firms that are more

mature have done equally poorly.

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3.9	What Explains Underpricing?

The tendency of IPOs to be underpriced is of interest for a variety of reasons. For exam-

ple, the underpricing of IPOs increases the cost of going public and may thus deter

some firms from going public. To investors, however, underpriced IPOs appear to pro-

vide “the free lunch,” or the sure thing, that most investors dream about. Before

Netscape went public, it was well known that its shares were going to be substantially

oversubscribed at the initial offering price and most analysts predicted that the stock

would trade well above this initial price in the secondary market. Indeed, investors who

bought at the offering price, and then sold their shares immediately in the secondary

market, more than doubled their money.

How Do I Get These Underpriced Shares?

As with most free lunches, there are hidden costs to the allocation of underpriced new

issues. It is not possible to simply open a brokerage account and expect to be able to

buy many new issues at the offering price. Investors should consider why underwrit-

ers underprice new issues before they attempt to realize the apparent profit opportunity

in this market.

The Incentives of Underwriters

In setting an offering price, underwriters will weigh the costs and benefits of raising

or lowering the issue’s price. Pricing an issue too low adds to the cost of going pub-

lic. Therefore, to attract clients, underwriters try to price their issues as high as possi-

ble. This tendency, however, is offset by the possibility that the issue may not sell if it

is priced too high, leaving the underwriter saddled with unsold shares. Because the cost

of having unsold shares is borne directly (firm commitment) or indirectly, as a loss of

reputation (best efforts), by the underwriter, it may have a substantial influence on the

pricing choice and even lead the underwriter to underprice the issue.

Baron (1982) analyzed a potential conflict of interest between underwriters and

issuing firms that arises because of their differing incentives and the underwriter’s bet-

ter information about market conditions. Given superior information, the underwriter

has a major say on the price of the issue. This will not be a problem if the underwriter

has exactly the same incentives as the issuing firm, but that is unlikely. The under-

writer’s incentive is to set the offering price low enough to ensure that all the shares

will sell without much effort and without subjecting the underwriter to excessive risk.

Underpricing the issue makes the underwriter’s job easier and less risky.

Although this explanation seems plausible and probably applies in some cases, a

study by Muscarella and Vetsuypens (1989) suggested that Baron’s explanation is prob-

ably incomplete. They examined a sample of 38 investment bankers who took them-

selves public and, hence, did not suffer from the information and incentive problems

suggested by Baron. These investment bankers underpriced their own stock an average

of 7 percent; the underpricing rose to 13 percent for the issuing firm that also was the

lead manager of the underwriting syndicate.

An underwriter might also want to underprice an issue because of the costs that

could arise from investor lawsuits brought on by a subsequently poor performance

of the issue. Tinic (1988) examined this possibility, arguing that concerns about

being sued increased following the Securities Act of 1933. Comparing a pre-1933

sample of issues to a post-1933 sample, Tinic found that the initial return, or the

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degree of underpricing, was much higher after the 1933 act, which lends support to

this theory.

Drake and Vetsuypens (1993), however, provided more recent evidence that makes

us somewhat skeptical about any large effect on pricing caused by concern over legal

liability. They examined 93 firms that were sued after their IPOs. The sued firms were

as underpriced as other IPOs, suggesting that underpricing an issue does not effectively

prevent lawsuits. Furthermore, the average settlement was only 15 percent of the pro-

ceeds, or roughly the same as the average amount of the underpricing. From the issu-

ing firm’s point of view, one cannot justify underpricing an issue by 15 percent sim-

ply to lower the chanceof a lawsuit that will cost 15 percent on average (assuming it

takes place). Nevertheless, since the underwriting firm may be the object of the law-

suit, it may still have an incentive to underprice the issue.

The Case Where the Managers of the Issuing Firm Have Better Information Than Investors

Often firms go public as a precursor to a larger seasoned issue in the near future. This

allows managers to first test the waters with a small issue and, if that issue is suc-

cessful, to subsequently raise additional equity capital. Investment bankers have fre-

quently suggested that it is a good idea to underprice the initial offering in these cir-

cumstances to make investors feel better about the secondary issue. The belief is that

investors will be more likely to subscribe to a firm’s seasoned offering after making

money in the IPO.

Anumber of academic papers have noted that entrepreneurs who expect their firms

to do well, and who have opportunities for further investment, will have the greatest

incentive to underprice their shares.¹⁵These papers argue that investors understand that

only the best-quality firms have the incentive to underprice their issues; therefore, these

investors take a more favorable view of the subsequent issues of firms that underpriced

their IPOs. The incentive to underprice an issue is therefore determined by a firm’s

intention to seek outside financing in the near future. Although this argument seems

plausible, empirical research on the pricing of new issues provides no support for this

hypothesis.¹⁶

The Case Where Some Investors Have Better Information Than Other Investors

An innovative paper by Rock (1986) explained the hazards of using one’s knowledge

that IPOs tend to be underpriced to place orders for all available IPOs. To understand

these hazards, recall the famous line by Groucho Marx, who said, “I would never join

a club that would have me for a member.”

To have an IPO allocated to you is a bit like being invited to join an exclusive

club. Since the hot issues are underpriced, on average, there is usually excess demand

that makes the shares difficult to obtain. While it might be nice to be asked to join a

club, you have to ask whether the club is really so exclusive if you were asked to join.

Likewise, it is important to ask whether the IPO is really so hot if your broker is able

to get you the shares.

¹⁵This

explanation for underpricing new issues is developed in papers by Allen and Faulhaber (1989),

Welch (1989), Grinblatt and Hwang (1989), and Chemmanur (1993).

¹⁶Garfinkel

(1993), Jegadeesh, Weinstein, and Welch (1993), and Michaely and Shaw (1994) look at

the relation between the amount an issue is underpriced and whether the issuer subsequently follows with

a secondary offering. All conclude that there is no such relation.

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86Part IFinancial Markets and Financial Instruments

To understand Rock’s argument, suppose that there are two kinds of investors: the

informed and the uninformed. Informed investors know the true value of the shares,

perhaps through costly research. Hence, they will put in an order for the IPO only when

the shares are underpriced. Uninformed investors do not know what shares are worth

and put in orders for a cross-section of IPOs. Unfortunately, they get allocated 100 per-

cent of the overpriced “dogs” and only a fraction of the underpriced “stars.”

If new issues are not underpriced, uninformed investors will, on average, system-

atically lose money. The allocation of the dogs to investors is an example of what econ-

omists refer to as thewinner’s curse, a term derived from an analysis of auctions, in

which the bidder who wins the auction ultimately realizes that he or she was willing

to pay more for the object than everyone else in the room_and thus overpaid. Simi-

larly, an investor who is allocated shares in an IPO could be subject to the winner’s

curse if he or she is allocated shares because more informed investors have chosen not

to purchase them. Because of this winner’s curse, individuals who are aware of their

lack of knowledge avoid auctions, and uninformed investors generally avoid buying

IPOs.

Rock’s article suggested that investment bankers, wanting to broaden the appeal of

the issues, may underprice the issues to induce uninformed investors to buy them. One

implication of this line of reasoning, supported by Beatty and Ritter’s study (1986), is

that riskier IPOs that are more subject to the winner’s curse must be underpriced more,

on average, than the less risky IPOs.

Koh and Walter’s (1989) study of IPOs in Singapore and Keloharju’s (1993) study

of IPOs in Finland provide more direct tests of Rock’s model. These countries use the

fixed-price method to distribute and allocate shares, and the degree of rationing is pub-

lic knowledge. The results of both studies show that (1) buyers receive more shares of

the overpriced issues and fewer shares of the underpriced issues, and (2) since investors

receive a greater allocation of the bad issues, on average, they realize zero profits from

buying IPO shares even though the shares are underpriced.

The Case Where Investors Have Information That the Underwriter Does Not Have

The Rock model provides a good explanation for underpricing in countries that use the

fixed-price method. In addition, the model provides an important lesson for uninformed

investors in the United States who learn about the average underpricing of IPOs and

see it as a profit opportunity. However, Rock’s model may not explain why issues tend

to be underpriced in the United States where a book-building procedure is generally

used.

Recall that with the book-building procedure, underwriters rely on information

learned from potential investors when they price the IPO. If investors express enthusi-

asm for the issue, the underwriter raises the price. If investors are less enthusiastic, the

underwriter lowers the price.

Because their information affects the price, investors have an incentive to distort

their true opinions of an IPO. In particular, investors might want to appear pessimistic

about the issuing firm’s prospects in hopes of getting allocated shares of the issue at

a more favorable price. Obtaining truthful information may be especially difficult

when there are one or two market leaders, such as Fidelity Investments, whose deci-

sions are likely to influence the decisions of other investors.¹⁷Welch (1992) suggested

¹⁷Benveniste

and Wilhelm (1997) report that Fidelity, one such market leader, buys about 10 percent

of all newly issued shares.

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87

that influential investors can play a very important role in determining the success or

failure of an offer because smaller investors may ignore their own information and

decide whether to subscribe to an issue based on the stated opinions of market lead-

ers. For example, if Fidelity expresses no interest in an issue, small investors may

choose to ignore their own information and decide not to participate in the offering,

causing the IPO to fail.

Benveniste and Spindt (1989) and Benveniste and Wilhelm (1990) suggested that

the way investment banks price and allocate the shares of new issues when they use a

book-building process may make it easier for them to elicit credible information from

their large investors. In particular, the authors suggested that IPOs are priced and the

shares are allocated as follows:

•	Investment banks underreact to information provided by investors when theyprice the IPOs.
•	Investors who provide more favorable information are allocated more shares.

The underreaction of investment banks to investor-provided information implies

that when investors do provide extremely favorable information, the banks are likely

to underprice the issue the most. Informed investors, therefore, would like to be allo-

cated a large share of these issues. Hence, to receive a greater allocation, investors

truthfully reveal their favorable opinion of the issue.

Hanley (1993) provided empirical evidence that investment banks price IPOs in

the manner suggested above. She classified IPOs according to whether the offering

prices were above or below the initial price range set by the investment banker in the

prospectus:

•	When investors express strong demand for an issue, the investment bankertends to price the issue above the expected price range listed in the prospectus.This occurred when Netscape went public. If investment bankers tend to underreact to information that strong investor demand for the IPO is likely,then these IPOs will be underpriced. Hanley found that IPOs priced above theinitial range were underpriced by about 20.7 percent, on average.
•	When the opinions expressed by investors corresponded with the investment banker’s initial expectations, the price of the issue generally fell within the expected price range stated in the prospectus. Hanley found that these IPOswere underpriced 10 percent, on average.
•	When the demand expressed by investors was relatively low, the issue isgenerally priced below the expected price range and might be withdrawn.These issues are expected to exhibit the least amount of underpricing. Hanley found that IPOs were underpriced only 0.6 percent, on average, when theofferings were priced below the expected range listed in the prospectus.

Individual investors hoping to gain from the underpriced new issues should be

aware that not all IPOs are underpriced, and that they may not be in a position to obtain

those IPOs that are.

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88	Part IFinancial Markets and Financial Instruments

3.10	Summary and Conclusions

This chapter reviews some of the institutional features ofchapters. For example, since firms generally raise sub-U.S. and overseas equity markets. It describes the variousstantial amounts of new equity when they go public, theequity instruments, the types of investors who hold thesedecision to go public must be considered along with theequity investments, and the markets on which they arefirm’s capital structure choice, which is examined in Parttraded. It points out there are many fewer types of equityIVof this text. Going public also affects the amount ofsecurities than there are debt securities. Although the eq-influence shareholders have on a corporation’s manage-uity markets are less dominated by institutions than are thement, which is examined in Part Vof this text. Finally,debt markets, it is still the case that in the United States, al-the decision to go public is strongly influenced by the dif-most half of all equities are held by institutions.ference between the fundamental value of the firm, as

The chapter also discussed the process by which firmsperceived by the firm’s management, and the price for thego public. When firms go public, they transform their pri-shares that can be obtained in the public markets. How-vate equity, which cannot be traded, into common stockever, this type of comparison requires additional knowl-that can be traded in the public markets. Our discussionedge of what determines both fundamental values andof the incentives of firms to go public raised a number ofmarket prices. The determination of these values is con-questions that will be addressed in more detail in latersidered in Parts II and III of this text.

Key Concepts

Result	3.1:	The stock market plays an important role in	Advantages
Result	3.2:	allocating capital. Sectors of the economythat experience favorable stock returns canmore easily raise new capital for investment. Given this, the stock market islikely to more efficiently allocate capital ifmarket prices accurately reflect the investment opportunities within an industry.IPOs are observed frequently in some yearsand not in other years. The available evidence suggests that the hot issue periodsare characterized by a large supply of available capital. Given this interpretation,firms are better off going public during ahot issue period.	•Better access to capital markets. •Shareholders gain liquidity. •Original owners can diversify. •Monitoring and information are provided by external capital markets. •Enhances the firm’s credibility with customers, employees, and suppliers. Disadvantages •Expensive. •Costs of dealing with shareholders. •Information revealed to competitors. •Public pressure.
Result	3.3:	The advantages and disadvantages of goingpublic are as follows:	In general, a firm should go public when the benefits of doing so exceed the costs.

Key Terms

adjustable-rate preferred stock70		efficient markets hypothesis75
American Depositary Receipts (ADRs)	73	exchange74
book-building process81		fixed-price method81
broker74		fourth market74
call options71		hot issue periods78
common stock69		liquidation70
convertible preferred stock70		limit order74
cumulative70		market order74
depth75		material information81
dual-class common stock69		monthly income preferred securities (MIPS)71
ECN74		oversubscribed offering81

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Chapter 3

Equity Financing

89

over-the-counter (OTC) market	73	third market	74
preferred stock70		unit offering	71
private equity77		venture capital	77
restructuring77		warrants71
secondary equity markets73		winner’s curse	86
specialist74

Exercises

3.1.The William Wrigley Jr. Company is the world’s3.4.Suppose your firm wants to issue a security which

largest maker of chewing gum. The CEO is Williampays a guaranteed fixed payment plus an additional

Wrigley, Jr., the son of the founder. Wrigley has twobenefit when the firm’s stock price increases.

classes of shares: common and class B stock. InDescribe how such a security can be designed, and

1995, there were 91.2 million shares of commonname existing securities that have this characteristic.

stock outstanding, entitled to one vote per share;3.5.When investment bankers bring a new firm to

there were also 25.1 million shares of class B stockmarket, do you think they have conflicting

outstanding with 10 votes per share. The Wrigleyincentives? What might these be and what are their

family owns directly or through trusts about 22.1causes?

million shares of common stock and about 12.9

3.6.During the late 1990s Internet IPOs were

million shares of class B stock. What percentage of

substantially more underpriced than the IPOs issued

the total votes do the Wrigleys control?

in earlier periods. Discuss why you think this may3.2.Accurately pricing a new issue is quite costly.have happened.

Explain why underwriters desire a reputation for

3.7.You are interested in buying 100 shares of Ajax

pricing new issues as accurately as possible.¹4and the ask

Products. The current bid price is 18

Describe the actions they take to ensure accuracy.¹2. Suppose you submit a market order. At

price is 18

3.3.Suppose a firm wants to make a $75 million initialwhat price is your order likely to be filled? What are

public offering of stock. Estimate the transactionthe advantages and disadvantages of submitting a

costs associated with the issue.limit order to purchase the shares at 18³8versus

putting in a market order?

References and Additional Readings

References and Additional Readings

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Allen, Franklin, and Gerald Faulhaber. “Signaling by

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Amihud, Yakov, and Haim Mendelson. “Liquidity and

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Strategy, Second Edition

90Part IFinancial Markets and Financial Instruments

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Reilly, Frank. “Further Evidence on Short-Run Results for

New-Issue Investors.” Journal of Financial and

Quantitative Analysis8 (1973), pp. 83–90.

———. “New Issues Revisited.” Financial Management

6 (1977), pp. 28–42.

Ritter, Jay. “The ‘Hot’Issue Market of 1980.” Journal of

Business57 (1984), pp. 215–40.

———. “The Costs of Going Public.” Journal of

Financial Economics19 (1987), pp. 269–82.

———. “The Long-Run Performance of Initial Public

Offerings.” Journal of Finance46 (1991), pp. 3–27.

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 3

Equity Financing

91

Rock, Kevin. “Why New Issues are Underpriced.”Journal of Accounting and Economics8 (1986),

Journal of Financial Economics15 (1986), pp. 197–216.

pp. 187–212.Story, Edward. “Alternative Trading Systems:Sanger, Gary, and John McConnell. “Stock ExchangeINSTINET.” In Trading Strategies and Execution

Listings, Firm Value, and Security MarketCosts. Charlottesville, VA: Institute of Chartered

Efficiency: The Impact of NASDAQ.” Journal ofFinancial Analysts, 1988.

Financial and Quantitative Analysis21 (1986), Tinic, Seha. “Anatomy of Initial Public Offerings of

pp. 1–25.Common Stock.” Journal of Finance43 (1988), Schultz, Paul. “Unit Initial Public Offerings: AForm ofpp. 789–822.

Staged Financing.” Journal of Financial EconomicsUttal, Bro. “Inside the Deal That Made Bill Gates

34 (1990), pp. 199–230.$350,000,000.” Fortune,July 21, 1986.Sherman, Ann E. (2001). “Global Trends in IPO Methods:Welch, Ivo. “Seasoned Offerings, Imitation Costs and the

Book Building vs. Auctions,” unpublished UniversityUnderwriting of IPOs.” Journal of Finance44,

of Notre Dame working paper.(1989), pp. 421–49.

Stickel, Scott. “The Effect of Preferred Stock Rating———. “Sequential Sales, Learning and Cascades.”

Changes on Preferred and Common Stock Prices.”Journal of Finance47 (1992), pp. 695–732.

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Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

92Part IFinancial Markets and Financial Instruments

PRACTICALINSIGHTSFORPARTI

Financing the Firm

•Debt is a more commonly used source of outside capital

and has lower transaction costs than equity financing.

(Sections 1.1,1.3)

•Advantageous financing terms are generally achieved

by understanding the frictions faced by investors and

trying to overcome them with clever security designs.

(Section 2.5)

•Euromarkets and foreign issues are attractive sources of

financing. It pays to be familiar with them. (Sections

1.4, 1.5, 2.6, 3.3)

•Debt instruments are complex, diverse, and filled with

conventions that make comparisons between financing

rates difficult. Get a full translation of all features and

rate conventions. (Sections 2.1–2.4, 2.8)

•Equity capital obtained during hot issue periods may be

cheaper than equity capital obtained at other times.

(Section 3.7)

•Include underpricing, which averages about 15 percent,

when figuring out the total cost of IPO equity financing.

(Section 3.7)

•Public capital is generally cheaper but comes with a

host of hidden costs that make it unattractive to some

firms. In particular, one should factor in the costs of

regulations imposed by government agencies and

exchanges on capital costs obtained from public

sources. Because of these costs, most small firms obtain

outside capital from private sources. (Sections 1.2, 1.3,

3.7)

Knowing Whetherand How to Hedge Risk•Before hedging, it is essential to be familiar with the

securities and derivatives used for hedging, and the

arenas in which these financial instruments trade.

(Sections 2.4, 2.7, 3.4)

•Issuing securities or entering into contractual

agreements often requires the aid of a trusted

investment banker and thus knowledge of how such

bankers operate. (Section 1.3)

Allocating Capital forReal Investment

•Stock prices can provide valuable information about the

profitability of projects in a firm or an industry.

(Section 3.5)

Allocating Funds forFinancial Investments

•Most debt instruments are not traded very actively.

Such illiquidity needs to be accounted for when making

investment decisions. (Section 2.7)

•When there are restrictions on investment for tax,

regulatory, or contractual reasons, the wide variety of

financial instruments available can allow one to skirt

these restrictions. (Sections 2.4, 2.5, 2.6, 3.1)

•Historically, IPOs have been good short-term

investments, especially for investors who can obtain hot

issues. (Sections 3.8, 3.9)

•Historically, the typical IPO has been a bad long-term

investment. (Section 3.8)

•When investing in debt instruments, one must have full

mastery of all of the debt quotation conventions.

(Section 2.8)

•Preferred stock investment is often motivated by tax

considerations. (Section 3.1)

•Commercial paper, while generally not traded, will

generally be redeemed early by the issuing corporation if

the investor requests it. It is almost as safe as Treasury

bills, yet offers more attractive rates, especially to tax-

advantaged institutions, like pension funds. (Section 2.3)

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Chapter 3

Equity Financing

93

EXECUTIVEPERSPECTIVE

Bruce Tuckman

Part I of this book introduces you to the process of raisingcapital, the diversity of traded securities, the complex fea-tures of debt securities, and the international nature oftoday’s markets. I received a preliminary version of thisbook just a week or two after the U.S. Treasury sold its firstissue of TIPS (i.e., “Treasury Inflation Protected Securi-ties”) in 1997. Immediately after the U.S. TIPS issue, theFederal Home Loan Bank, J. P. Morgan, Salomon Brothers,and Toyota also sold inflation-linked bonds. It struck methat, as a reader of Part I, you would have been well pre-pared to analyze this new development in financial marketsbecause the basics required are included there.

The most important feature of TIPS is that their pay-ments increase with the inflation rate, thus “protecting”investors from declines in the purchasing power of fixedcash flows. Several countries issued similar securitiesyears ago, including the United Kingdom, Canada, andSweden. Why had these countries issued inflation-protected securities before the United States? Further-more, newspapers at the time of the U.S. issue reportedthat foreign investors showed great interest in the U.S.issue. Why would that be the case? So, you see, what atfirst seemed to involve only a domestic market cannot beunderstood except in its international context.

It was also interesting to speculate on why other U.S.issuers sold inflation-protected bonds so soon after theU.S. Treasury did so. Or, put another way, if there was amarket for these securities, why did the issuers wait solong? Rumors began that some of the issuers had swapped

their inflation-indexed liabilities for other floating ratecash flows. This led to a question: who took the other sideof these swaps? Here we have a phenomenon in the cor-porate bond market depending on something happening inthe swap market.

The TIPS issue also involved a myriad of details onehad to understand. Here are some examples. First, theTreasury decided to delay the issue from January 15 toJanuary 29, 1997. But, to keep the bond cash flows in linewith those of other bonds, the Treasury kept coupon dateson July 15 and January 15 and kept the maturity date onJanuary 15, 2007. Hence, this bond has a short firstcoupon, a topic discussed in Chapter 2 of this text. Second,the cash flows of all the indexed bonds depend on theinflation levels two and three months before the cash flowdate. As a result, for some time after issue and after eachcash flow date, the subsequent cash flow is not known inadvance. So how do we compute accrued interest? Third,since the cash flows of this bond are not known inadvance, how do we compute a yield measure? Fourth, theTreasury bonds were strippable, so we may some day haveinflation indexed zeros.

I’m sure you see that you can follow this discussionbecause of the material you’ve read in this part.

Mr. Tuckman currently is a managing director at Credit Suisse FirstBoston. Previously, he taught at New York University’s Stern School of

Business, where he was an Assistant Professor of Finance. He is theauthor of Fixed Income Securities: Tools for Today’s Markets.

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PART
II
	Valuing	Financial Assets

The modeling of how prices are determined in markets for financial assets (for exam-

ple, stocks, bonds, and derivatives) is very different from the way prices are mod-

eled for consumer goods in economics. In economics, the prices of goods, such as guns

and butter, are determined by specifying how consumer preferences for guns and but-

ter interact with the technology of producing them. By contrast, finance is focused on

valuing assets in relation to the values of other assets.

This difference in focus often allows the field of finance to dispense with the lan-

guage of preferences (for example, utility functions, indifference curves) and the lan-

guage of production technology (for example, marginal cost) which is so often used in

economics. Instead, financial valuation has its own language. It uses terms like arbi-

trage, diversification, portfolios, tracking, andhedging.

The next five chapters illustrate this point nicely. Chapter 4 introduces portfolios,

which are simply combinations of financial assets, and the tools needed to manage

them. An understanding of the concepts introduced in this chapter provides the frame-

work that we will use to value a financial asset in relation to other financial assets. In

particular, most of the valuation of financial assets in Chapters 5–8 is based on a com-

parison of the financial asset to be valued with a portfolio whose value or rate of

expected appreciation is known. The latter portfolio, known as the tracking portfolio,

is designed to have risk attributes identical to the stock, bond, option, or other finan-

cial asset that one is trying to value.

The ability to form portfolios also leads to another major insight: diversification.

Diversification means that investors might be able to eliminate some types of risk by

holding many different financial assets. The implications of diversification are pro-

found. In particular, it implies that the tracking portfolio to which one compares a finan-

cial asset need not match the asset being valued in allrisk dimensions—only in those

risk dimensions that cannot be diversified away.

We use the theme of the tracking portfolio throughout much of this text. It is first

developed in Chapter 5, where the portfolio tools from Chapter 4 are applied to deter-

mine how to invest optimally and the first major valuation model, known as the Cap-

ital Asset Pricing Model, is developed. This model suggests that the expected returns

of all investments are determined by their market risk. In this model each financial

asset is tracked by a combination of a risk-free security and a special investment known

as the market portfolio. The precise weighting of the combination varies from asset to

asset and is determined by the asset’s market risk. The expected return of this tracking

portfolio has to be the same as the expected return of the tracked asset. The tracked

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Strategy, Second Edition

96Part IIValuing Financial Assets

asset’s market risk determines the composition of the tracking portfolio. Thus it indirectly

determines the expected return of the tracked asset. It is in this sense that the Capital Asset

Pricing Model values each asset in relation to its tracking portfolio.

The theme of the tracking portfolio is carried further in Chapter 6, where we

develop a statistical tool known as a factor model and show how combining factor mod-

els with the clever formation of portfolios leads to a valuation insight known as the

arbitrage pricing theory. According to this theory, the expected returns of assets are

determined by their factor risk. In this model, each financial asset is tracked by a com-

bination of a risk-free security and special investments known as factor portfolios. The

expected return of this factor-based tracking portfolio determines the expected return

of the tracked asset.

If the expected return relationship between the tracked asset and its tracking port-

folio does not hold, an arbitrage opportunitywould arise. This concept leads to pow-

erful insights into valuation. An arbitrage opportunity,which essentially is a money

tree, is a set of trades that make money without risk. Specifically, an arbitrage oppor-

tunity requires no up-front cash and results in riskless profits in the future.¹

The arbitrage opportunity that arises when the valuation relationship between an

asset and its tracking portfolio is violated involves buying the misvalued investment

and hedging its risk by taking an opposite position in its tracking portfolio, or vice

versa. This arbitrage opportunity exists not only because of the ability to form track-

ing portfolios that match the factor risk of the investment being valued, but also because

of the ability to form diversified portfolios, first discussed in Chapter 4.

Diversification plays no role in the valuation of derivatives, discussed in Chapters

7 and 8. This is because the tracking portfolio in this case, a combination of the under-

lying financial asset to which the derivative is related and a risk-free asset, tracks the

derivative perfectly. Once again, arbitrage opportunities are available unless the deriv-

ative security has the same price as its tracking portfolio.

The perfect tracking of derivatives comes at the cost of additional complexity. A

dynamic strategy in which the weighting of this combination is constantly changing is

typically required to form the tracking portfolio of a derivative. This can make the val-

uation formulas for derivatives appear to be fairly complex in relation to the valuation

formulas developed in Chapters 5 and 6.

All of the key insights developed in Part II are essential not only for investment

in financial assets, but for the ongoing valuation of real assets (for instance, machines

and factories) that takes place in corporations. The analysis of real asset valuation is

developed in Part III of the text. The techniques developed in Part II also are useful

for understanding some aspects of financial structure developed in Part IVof the text,

and the theory of risk management, developed in Part VI of the text. In particular, we

use the mathematics of portfolios repeatedly and make liberal use of tree diagrams,

which are seen in great detail in Chapters 7 and 8, in much of our later analysis. Finally,

portfolio tools and financial asset valuation are useful for understanding some issues

in corporate control, asymmetric information, and acquisition valuation, developed in

Part Vof the text. As such, Part II is central to what follows. Even students with a

background in investment theory should review these chapters before proceeding to the

remainder of the text, which is devoted almost entirely to corporate applications.

¹Chapters 7–8 provide a variation of this definition: riskless cash today and no future cash paid out.

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Strategy, Second Edition

CHAPTER
4
	Portfolio	Tools

Learning Objectives

After reading this chapter, you should be able to:

1.Compute both the covariance and the correlation between two returns given

historical data.

2.Identify a mean-standard deviation diagram and be familiar with its basic elements.

3.Use means and covariances for individual asset returns to calculate the mean and

variance of the return of a portfolio of N assets.

4.Use covariances between stock returns to compute the covariance between the

return of a stock and the return of a portfolio.

5.Understand the implications of the statement that “the covariance is a marginal

variance” for small changes in the composition of a portfolio.

6.Compute the minimum variance portfolio of a set of risky assets and interpret the

equations that need to be solved in this computation.

The 1990s saw the proliferation of hedge funds, which are portfolios that are actively

managed but which are exempt from the 1940 Investment Companies Act of the U.S.

Congress. This decade also witnessed the proliferation of what are known as “funds of

funds.” Funds of funds, as the name implies, typically pool money to invest in several

hedge funds (sometime dozens of funds) at a time. Investing via a fund of funds allows

some investors to escape minimum investment requirements. For example, some hedge

funds require a minimum investment of $5,000,000. Atypical minimum investment for a

fund of funds is substantially lower. Funds of funds also investigate the managers of

hedge funds and evaluate their talent. However, the major function that funds of funds

produce is diversification. For example, many funds of funds examine the track records

of a group of hedge funds and allocate capital to each hedge fund manager in a

manner that minimizes the variance of the return of the fund of funds.

The modern theory of how to invest, originally developed by Nobel laureate in eco-

nomics Harry Markowitz, plays a role in almost every area of financial practice

and can be a useful tool for many important managerial decisions. This theory was

developed to help investors form a portfolio—a combination of investments—that

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98Part IIValuing Financial Assets

achieves the highest possible expected return¹for a given level of risk. The theory

assumes that investors are mean-variance optimizers; that is, seekers of portfolios with

the lowest possible return variancefor any given level of mean (or expected) return.

This suggests that the varianceof an investment return, a measure of how dispersed

its return outcomes are, is the appropriate measure of risk.²

The term coined by Markowitz for this theory, mean-variance analysis, describes

mathematically how the risk of individual securities contributes to the risk and return

of portfolios. This is of great benefit to portfolio managers making asset allocation

decisions, which determine how much of their portfolio should be earmarked for each

of the many broad classes of investments (for example, stocks, bonds, real estate, Japa-

nese equities). Mean-variance analysis also is useful to corporate managers. Financing

represents the opposite side of investing. Just as portfolio tools help an investor under-

stand the risk he bears, they also help a corporate manager understand how financial

structure affects the risk of the corporation. Moreover, most large corporations contain

a number of different investment projects; thus, a corporation can be thought of as a

portfolio of real assets. Although the objectives of a corporate manager differ from

those of a portfolio manager, the corporate manager is interested in how the risk of

individual investments affects the overall risk of the entire corporation. Mean-variance

analysis provides the necessary tools to evaluate the contribution of an investment proj-

ect to the expected return and variance of a corporation’s earnings. In addition, corpo-

rate managers use mean-variance analysis to manage the overall risk of the firm.³

Finally, mean-variance analysis is the foundation of the most commonly used tool for

project and securities valuation, the Capital Asset Pricing Model (CAPM),a theory that

relates risk to return (see Chapter 5).

Diversification, the holding of many securities to lessen risk, is the most impor-

tant concept introduced in this chapter. It means that portfolio managers or individual

investors balance their investments among several securities to lessen risk. As a port-

folio manager or individual investor adds more stocks to his portfolio, the additional

stocks diversifythe portfolio if they do not covary (that is, move together) too much

with other stocks in the portfolio. Because stocks from similar geographic regions and

industries tend to move together, a portfolio is diversified if it contains stocks from a

variety of regions and industries. Similarly, firms often prefer to diversify, selecting

investment projects in different industries to lower the overall risk of the firm. Diver-

sification is one factor that corporate managers consider when deciding how much of

¹Areturnis profit divided by amount invested. Formally, the return, R, is given by the formula:

PDP

R ¹10

P

0

where

P End-of-period value of the investment

1

P Beginning-of-period value of the investment

0

D Cash distributed over the period

1

The three variables for determining a return are thus: beginning value, ending value, and cash

distributed. Beginning value is the amount paid for the investment. Similarly, end-of-period value is the

price that one would receive for the investment at the end of the period. One need not sell the

investment to determine its end-of-period value. Finally, the cash distributions are determined by the type

of investment: cash dividends for stocks, coupon payments for bonds.

²Other measures of risk exist, but variance is still the predominant measure used by portfolio

managers and corporate managers.

³See Chapter 22.

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Chapter 4

Portfolio Tools

99

a corporation’s capital to allocate to operations in Japan, Europe, and the United States

or, for example, when deciding how much to invest in various product lines. Diversi-

fication is also relevant to the management of a firm’s pension fund and the manage-

ment of risk.

Many pension funds place a portion of their assets with hedge funds, acting indi-

rectly as a fund of funds. The managers of funds of funds, described in the opening

vignette, fully understand the principle of diversification. They understand not only that

placing capital with many hedge fund managers reduces risk but that a precise quanti-

tative weighting of the fund managers in their portfolio of fund managers can reduce

risk even further. Chapter 4 provides tools that are part of an essential toolkit neces-

sary for running a fund of funds, whether explicitly or implicitly (as a pension fund

trustee who allocates capital to hedge fund managers).

While the principle of diversification is well known, even by students new to

finance, implementing mean-variance analysis—for example, coming up with the

weights of portfolios with desirable properties, such as a portfolio with the lowest vari-

ance—requires some work. This chapter will examine some of the preliminaries needed

to understand how to implement mean-variance analysis. It shows how to compute sum-

mary statistics for securities returns, specifically, means, variances, standard deviations,

covariances,and correlations,all of which are discussed later in the chapter. These are

the raw inputs for mean-variance analysis. It is impossible to implement the insights

of Markowitz without first knowing how to compute these raw inputs.

This chapter also shows how the means, variances, and covariances of the securi-

ties in the portfolio determine the means and variances of portfolios. Perhaps the key

insight a portfolio manager could learn from this analysis is that the desirability of a

particular stock is determined less by the variance of its return and more by how it

covaries with other stocks in the portfolio.