Question

b. Discuss why the majority of IPOs are usually underpriced. What role do investment banks play in this process?

c. Distinguish between systematic and unsystematic risk. Can diversification reduce all risk? Why or why not?

Answer 1

IPO or the initial public offering is a process by which a company goes public by issuing shares in the primary market and on listing on exchanges their shares are publicly traded in the secondary market

IPOs are under-priced for the following reasons :

· Under-priced IPOs improves the confidence among the investors & boosts the demand .

· Since the company is new to be listed , the correct pricing may not attract many investors as the risk involved in investment is high at the beginning.

· On listing in the secondary market , the demand and supply of the shares on further improvement further increases the value of the stock improving investor confidence about the company and attracts new investors in the secondary market .

Role of investment banks :

· Investment banks play a major role in the valulation process of the ipo.

· They appoint merchant bankers and book runners to oversee and sail through the IPO issue processs

· The draft read hearing prospectus is drafted and filed with the exchange

· They acts on behalf managers to the issue.

· The price band is decided for the issue The syndicate memebers and collection centres for the IPOss are determined by the investment banks

· Once the biddings are received the shares are allocated to the isvetors by the ASBA account Based on the proportionate under/ over subscription .

Part II

Systematic Risk	Unsystematic Risk
Systematic Risk is the market specific risk which exists in all situations	Unsystematic risk is the security specific risk and doesn’t depend on the overall market
Systematic risk cannot be diversified	Unsystematic risk can be diversified using proper diversification techniques
Mainly affected by the economies and the country of the operation	Not at all related with the economies and only related to the specific selected security
Beta is the measure of the systematic risk	It is defined as a variable function of a series of diversifiable components
Hedging techniques using Futures and options are generally used to reduce the quantum of risk in the portfolio	Use of Highly negatively correlated securities are use in order to reduce the unsystematic risk

Diversification can only reduce the amount of unsystematic risk , but it cannot completely eliminate the unsystematic risk . this is because only the use of perfectly negatively correlated securities with (correl coefficient = ro = -1) can reduce and nullify this risk , and it is virtually impossible to have perfectly negatively correlated securities in the portfolio . As such a certain portion of the risk still remains in the portfolio even if it is well diversified