This study investigates underpricing of IPOs in Sri Lanka. On average, IPOs are underpriced by 34%. Small issues are more underpriced than large issues, and privatization issues are more underpriced than conventional issues. Investor sentiment is positively related with underpricing and affects small and large issues similarly. Small privatization issues are more underpriced than large privatization issues and partially explain the asymmetry in underpricing between small and large issues. However, even after controlling for investor sentiment, privatization, hot-market conditions, underwriter-size, and industry, small issues remain more underpriced than large issues. The results strongly support the uncertainty hypothesis for larger underpricing of small issues, and privatization issues.

1. Short-run Underpricing of Initial Public
Offerings in the Sri Lankan Stock Market
Lalith Samarakoon
Department of Finance
Opus College of Business
University of St. Thomas
April 29, 2011

2. Short-run IPO Underpricing
Purpose of Research
 Investigate the initial underpricing of IPOs in the Colombo
Stock Exchange
 Initial Underpricing: positive first day return i.e.,
increase in price on the first day of trading relative to
the offer price
 Contribution
 Provide Sri Lankan IPO evidence to international
literature; no prior published work on IPOs in the Sri
Lankan market
 Examine the ability of investor sentiment and
privatization to explain the asymmetry in underpricing
between small and large issues in an emerging market
2

3. Short-run IPO Underpricing
Main Hypothesis
 Ex-ante uncertainty hypothesis [Ritter (1984), Beatty and
Ritter (1986)]
 Uncertainty about the value of the issue; risky issues must
be more underpriced
 Small issues are considered more risky than large issues;
Smaller issues will be more underpriced [Ritter (1984),
Beatty and Ritter (1986)]
 Privatization issues are considered more risky than
conventional issues; Privatization issues will be more
underpriced [Jones et al. (1999), Perotti and Guney (1998)]
 Investor sentiment hypothesis
 Sentiment about the short-term direction of the overall
market [Ritter (1984)]
 More positive sentiment will lead to more underpricing
3

4. Short-run IPO Underpricing
Table 1: The Sample
Year or Industry Number of IPOs Aggregate
Proceeds
Conventional
Issues
Privatization
issues
Total Rs.
Mn.
%
Panel A: By Year
1987 3 0 3 147 0.92
1988 7 1 8 132 0.83
1989 1 1 2 140 0.88
1990 1 0 1 7 0.04
1991 3 1 4 139 0.87
1992 7 2 9 1,765 11.05
1993 7 3 10 1,631 10.21
1994 12 3 15 3,248 20.34
1995 11 3 14 2,428 15.21
1996 2 7 9 1,573 9.85
1997 4 2 6 833 5.22
1998 1 4 5 330 2.07
1999 3 1 4 496 3.11
2000 1 2 3 100 0.63
2001 0 0 0 - -
2002 3 0 3 133 0.83
2003 5 0 5 1,170 7.33
2004 1 0 1 300 1.88
2005 1 0 1 600 3.76
2006 1 0 1 400 2.51
2007 0 0 0 - -
2008 1 0 1 396 2.48
Total 75 30 105 15,968 100.00
4

5. Short-run IPO Underpricing
Table 1: The Sample Continued
5
Year or Industry Number of IPOs Aggregate Proceeds
Conventional
Issues
Privatization
issues
Total Rs. Mn. %
Panel B: By Industry
Bank, finance & insurance 18 2 20 3,747 23.46
Beverage, food & tobacco 6 1 7 1,040 6.51
Chemicals & pharmaceuticals 0 1 1 3 0.02
Diversified 2 0 2 1,225 7.67
Footwear & textiles 0 3 3 478 2.99
Health care 3 0 3 721 4.51
Hotels & travels 12 1 13 1,570 9.83
Information technology 1 0 1 100 0.63
Land & property 7 0 7 298 1.86
Manufacturing 17 5 22 4,129 25.86
Motors 0 2 2 226 1.42
Plantations 1 15 16 877 5.49
Power & energy 1 0 1 400 2.50
Services 1 0 1 113 0.71
Trading 6 0 6 1,042 6.53
Total 75 30 105 15,968 100.00

6. Short-run IPO Underpricing
Methodology
 Calculating Initial Returns
 Univariate Analysis of Underpricing:
 Issue year
 Issuer’s industry
 Issue size
 Investor sentiment
 Privatization vs. conventional issues.
i
ii
i
PriceOffer
PriceOfferCloseDay-First
IR
−
=
Where, i= ith issue
6

7. Short-run IPO Underpricing
Methodology
 Cross-sectional Analysis
ii8i7i654
i3i2i1i
εManuβPlanβFootβrSizeUnderwriteβHotβ
PrivartizeβSentimentβSizeβαReturnInitial
++++++
+++=
 Independent variables
 Size (-): natural logarithm of proceeds of the issue
 Sentiment (+): cumulative market return over the three-month period
before the first day of trading of the IPO
 Privatize (+): a dummy variable equal to 1 for privatization IPOs and 0
for conventional IPOs.
 Hot (+): a dummy variable, which is set equal to 1 for hot market years
(1991 & 1998) and 0 otherwise
 UnderwriterSize (-/+): a dummy variable representing the size of the
underwriter and takes the value of 1 for large underwriters and 0 for
small underwriters
 Industry dummies (Foot, Plan, Manu)
7

8. Short-run IPO Underpricing
Table 2: Average Initial Returns by Issue Year
Year Average initial return Average initial return (%) Aggregate amount
left
on the table
(Rs. Mn.)
Annual market
return
(%)% t-stat Conventional
issues
Privatization
issues
1987 35.2 0.05 35.2 - 8.5 55.1
1988 5.6 -1.17 5.4 7.5 22.3 -23.0
1989 5.0 -0.61 0.0 10.0 9.0 6.4
1990 85.0 0.78 85.0 - 6.0 114.2
1991 106.9 2.12** 50.8 275.0 135.0 118.0
1992 46.0 0.54 54.5 16.3 267.0 -27.8
1993 38.2 0.22 23.0 73.7 502.8 61.7
1994 33.2 -0.01 13.4 112.4 1,102.3 0.8
1995 25.0 -0.44 22.9 32.8 42.3 -32.7
1996 21.1 -0.54 -33.0 36.5 -357.2 -9.2
1997 40.7 0.26 -11.9 145.8 163.6 16.5
1998 100.5 2.16** 9.1 123.3 312.0 -14.9
1999 -2.5 -1.08 11.7 -45.0 36.0 -4.2
2000 33.3 -0.00 20.0 40.0 36.0 -21.8
2001 - - - - - 38.8
2002 8.9 -0.64 8.9 - -21.7 31.3
2003 20.5 -0.43 20.5 - 590.3 30.3
2004 37.5 0.06 37.5 - 112.5 41.8
2005 25.0 -0.13 25.0 - 150.0 27.6
2006 -12.5 -0.69 -12.5 - -50.0 41.6
2007 - - - - - -6.7
2008 -10.4 -0.66 -10.4 - -41.3 -40.9
Overall 33.5
(66.2)
3,025.6 18.3
(43.2)
8

9. Short-run IPO Underpricing
Table 3: Average Initial Returns by Industry
Industry Average initial return Average
initial returns (%)
% t-stat Conventional
issues
Privatization
issues
Bank, finance & Insurance 5.5 -1.85* 5.8 2.5
Beverage, food & tobacco 11.4 -0.88 9.8 20.8
Chemicals & pharmaceuticals 7.5 -0.39 - 7.5
Diversified 44.8 0.24 44.8 -
Footwear & textiles 107.0 1.83* - 107.0
Health Care 19.2 -0.37 19.2 -
Hotels & travels 16.6 -0.88 6.5 137.5
Information technology -33.3 1.00 -33.3 -
Land & property 10.4 -0.91 10.4 -
Manufacturing 51.5 1.10 51.3 52.4
Motors 36.8 0.07 - 36.8
Plantations 76.9 2.39** 0.00 82.0
Power & energy -12.5 0.69 -12.5 -
Services 1.8 -0.48 1.8 -
Trading 27.7 -0.21 27.7 -
9

10. Short-run IPO Underpricing
Table 4: Initial Returns by Issue Size
Issue size Average
initial return
(%)
Standard
deviation
of initial returns
(%)
Average size
(Rs. Mn.)
Number
of IPOs
Number %
Panel A: Size category (Rs. Mn.)
0 < Size ≤ 50 50.0 72.7 27 36 34
50 < Size ≤ 150 37.4 68.7 93 35 33
150 < Size ≤ 750 11.9 50.4 345 34 33
Panel B: Small vs. large issues
Small 50.8 76.6 43 56 53
Large 13.6 44.9 277 49 47
Small – Large
37.2
(3.08)***
10

11. Short-run IPO Underpricing
Table 5: Initial Returns by Investor Sentiment
11
Investor sentiment
(Market return %)
Average
initial return
(%)
Standard
deviation
of initial returns
(%)
Average sentiment
(Market return)
( %)
Number
of IPOs
Number %
-27% < Market return ≤ -6% 26.0 60.0 -13.7 36 34
-6% < Market return ≤ 5% 34.6 72.3 -0.8 35 33
5% < Market return ≤ 42% 40.3 67.0 17.6 34 33

12. Short-run IPO Underpricing
Table 6: Initial Returns by Privatization vs. Conventional Issues
Issuetype Average
initialreturn
(%)
Standard
deviation
ofinitialreturns
(%)
Number
ofIPOs
Number %
Privatization 68.5 85.3 30 29
Conventional 19.4 51.0 75 71
Privatization -Conventional
49.1
(2.95)***
12

13. Short-run IPO Underpricing
Table 7: Cross-sectional Regression of Initial Returns
Model 1 2 3 4 5 6 7 8 9
Constant 0.87
(3.51)***
0.33
(5.31)***
0.19
(3.32)***
0.27
(4.50)***
0.22
(2.45)**
0.31
(5.07)***
0.26
(3.97)***
0.29
(4.43)***
0.52
(2.03)**
Size -0.12
(-2.46)**
-0.10
(-1.91)*
Sentiment 1.06
(2.12)**
1.17
(2.50)**
Privatize 0.49
(3.00)***
0.33
(2.04)**
Hot 0.76
(2.42)**
0.57
(2.27)**
UnderwriterSize 0.32
(2.21)**
0.23
(1.95)*
Foot 0.75
(1.10)
Plan 0.51
(2.59)**
0.04
(0.20)
Manu 0.23
(1.19)
Adj-R2
0.04 0.05 0.11 0.11 0.06 0.03 0.07 0.01 0.31
13
ii8i7i654
i3i2i1i
εManuβPlanβFootβrSizeUnderwriteβHotβ
PrivartizeβSentimentβSizeβαReturnInitial
++++++
+++=

14. Short-run IPO Underpricing
Table 8: Analysis of Small vs. Large Issues by Investor Sentiment, and Privatizaion vs. Conventional Issues
Sentiment Initial returns (%) Standard deviation
of initial returns
(%)
Number of IPOs
Small Large Small-
Large
Small Large Small Large Total
Panel A: Small vs. large issues by investor sentiment
Positive 59.2 21.7 37.5
(1.85)*
80.5 60.5 25 24 49
Negative 44.0 5.9 38.1
(2.75)***
73.9 20.0 31 25 56
Positive – Negative 15.4
(0.73)
15.8
(1.21)
Panel B: Small vs. large issues by privatization vs. conventional issues
Privatization 82.6 35.7 46.9
(1.39)
83.3 85.4 21 9 30
Conventional 31.7 8.7 23.0
(1.90)*
66.3 29.1 35 40 75
Privatization - Conventional 50.9
(2.39)**
27.0
(0.94)
14

15. Short-run IPO Underpricing
Summary and Implications
15
 IPOs in Sri Lanka are underpriced by about 34%.
 Small issues are more underpriced than large issues by about
37%, and issue size is negatively related related with
underpricing.
 Investor sentiment is positively related with underpricing
 Investor sentiment affects both small and large issues
similarly and does not explain the difference in underpricing
between small and large issues.
 Privatization issues are more underpriced than conventional
issues by a large 49%, and privatization is positively related
with underpricing.
 Difference in underpricing between small vs large issues is
much larger in privatization issues than in conventional
issues.
 This partially explains the difference in initial returns
between small vs. large issues.

16. Short-run IPO Underpricing
Summary and Implications
16
 There exists a privatization effect: Although small privatization
issues are more underpriced than large privatization issues, the
risks of the two groups are similar.
 However, even after controlling for investor sentiment,
privatization, hot markets, underwriter size and industry, small
issues are reliably more underpriced than large issues.
 Overall, the results provide strong support to the uncertainty
hypothesis as an explanation for larger underpricing of small
issues and privatization issues.

17. International Evidence
Short-run IPO Underpricing 17
 Loughran, T., Ritter, J. R., Rydqvist, K., 2010. Initial public offerings: International insights,
http://bear.warrington.ufl.edu/ritter/Int.pdf.