effort. Clearly, this situation cannot be an equilibrium.
In contrast, it may constitute a Nash equilibrium if shares trade below
the expected equilibrium value (see, e.g., von Lilienfeld-Toal (2006)). In this
equilibrium, outside investors fear to bid up the share price to its expected
equilibrium value because bidding up the price will trigger the owner man-
ager to sell her shares.17 Consequently, it may be in the interest of investors
not to bid up the share price but to trade below this value. Long run positive
abnormal returns are the natural consequence. This line of reasoning hinges
on three main assumptions:
1. Non-atomistic stock market
In order for underpricing equilibria to exist, not all investors in the
stock market can be atomistic price takers (see, e.g., Gorton and He
(2006) and von Lilienfeld-Toal (2006)). Stock market participants are
assumed to be price takers in traditional asset pricing models. This
assumption might be questionable in modern stock markets. In recent
years there is an increasing trend towards institutional stock owner-
ship. Sias and Starks (1998) report that institutional ownership in U.S.
equities rose from 24.2% in 1980 to nearly 50% in 1994. More recent
numbers provided by the Conference Board suggest that by the end
of 2005 nearly 70% of the 1,000 largest U.S. companies were held by
institutions.18 Many of those hold significant shares of the companies
they invest in. Consequently, it seems plausible that not all investors
are price takers. While the market microstructure literature has long
recognized that not all market participants are price takers (see, e.g.,
17 Gorton and He (2006) analyze similar issues in private bilateral bargaining situations.
18Press release by the Conference Board, Jan 22, 2007.
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