Oversubscription is a common phenomenon in initial public offerings (IPOs) and generally in the finance world. It is described as the surplus number of shares or bonds that investors would like to purchase but are not accessible due to high demand. It is mainly created in cases that a promising firm enters the market or when a company has a much lower offer price than the one expected by the investors.
Since an investor’s decision is influenced by that of others, there is herding into subscribing or abstaining. As a result there can be cases of overwhelming oversubscription. As an example there has been an IPO in a major European stock exchange, which in year 2000 experienced an oversubscription of 753.41 times.
The total number of shares the firm desired to issue was 6 million and the total demand from the public was 4.52 billion. The underwriters’ work became very dificult in allocating the shares; they failed in doing their job well as they left a lot of money in the table due to underpricing.
Rock’s “winner curse” model (1986) reports that both informed and uninformed investors apply for “good issues,” while only uninformed investors apply for “bad issues.” this is the reason why “good issues” are more likely to be oversubscribed.
Chowdhry and Sherman (1996) suggest that given the higthlevels of oversubscription, the cost to the issuing firm of underpricing may be mitigated by the interest earned on the subscription pool.
Therefore, the offer price is lowered and a large oversubscription for firms’ shares would be expected. Alternatively, there will be instances when investors would realize that the offer price is too high and the issue would fail.
Amihud et al. (2003) present a different argument on oversubscription. They report that excess demand is affected by factors that are known before the IPO, such as issue characteristics and market conditions. In this case, underpricing has, as its primary purpose, to attract some level of oversubscription, and that issue must be priced with high underpricing.