Question

Loughran & Ritter (2002) argue that prospect theory provides an explanation for underpricing. What is prospect theory and how does it advance our knowledge of the IPO market?

Answer 1

Loughran & Ritter (2002) provided the analysis of prospect theory in repect to the bargain at the pricing meeting. They argue that prospect thoery provides an explaination for underpricing.

Prospect theory states the behaviour of decision makers in choosing the investment alternative in terms of expected utility rather than absolut items. Decision makers prefers to choose certain gains over the larger gains with more risk involved.

Prospect theory is a behavioural study which studies the choosing behaviour from various alternatives for expected utility realtive to the wealth. IPO decision makers do not switch the underwriters if they are satisfied with the performance of underwriters. If underwriters gain enough compensation from issuer and investors, he will set the low price which results in more money on the table and creating wealth for the issuer. IPO decision makers gain by average high return IPOs with good performance where price has risen far above the filling range. These decision makers do not care of more wealth as they are already gaining the expected utility.