PRICE STABILIZATION AS A BONDING MECHANISM IN NEW EQUITY ISSUES

Underwriters have an incentive to overstate investor interest in order to persuade some investors to purchase shares at a price in excess of their initial estimate of the fair value. We show that this incentive is eliminated when the underwriter commits to secondary market price stabilization. Destroying the underwriter's incentive to overstate int erest reduces the total surplus captured by initial investors in initi al public offerings. Further efficiency gains are associated with pena lty bid systems that permit the underwriter to make the stabilization commitment selectively. Price stabilization can thus be viewed as a bo nding mechanism that improves the efficiency of the primary equity mar ket.