Prospect Theory and IPO Returns in China

This paper investigates whether prospect theory (PT) or a preference for lottery-like gains on stocks can explain the peculiarities of IPO returns in China. Chinese IPOs offer investors two potential lottery-like gains. One is potentially huge first day returns as Chinese issuers leave more money on the table and the other is that a particular IPO may in the long run become the next Alibaba. Consistent with the skewness preference hypothesis, we find that expected skewness is associated with high first-day returns and low long-term performance for a sample of 748 book-built Chinese IPOs issued over the 2005-2012 period. A one-standard-deviation increase in the expected skewness of an IPO stock can not only lead to an increase of 6.67 percentage points in the first-day return but also predict a decrease of 10.80-12.23 percentage points in the post-IPO abnormal return. Further analysis suggests that retail demand around the IPO event tends to increase with expected skewness, indicating that PT investors indeed overweight those extremely low probability events, leading to high first-day returns and low long-term abnormal returns.