Market Making Contracts, Firm Value, and the IPO Decision
44 Pages Posted: 17 Aug 2012 Last revised: 18 Feb 2017
Date Written: December 14, 2014
We examine the effects of secondary market liquidity on firm value and the decision to conduct an Initial Public Offering (IPO). Competitive liquidity provision can lead to market failure as the IPO either does not occur or the IPO price is discounted to reflect that some welfare-enhancing secondary trades do not occur. Market failure arises when uncertainty regarding fundamental value and asymmetric information are large in combination. In these cases, firm value and social welfare are improved by a contract where the firm engages a Designated Market Maker (DMM) to enhance liquidity. Our model implies that such contracts represent a market solution to a market imperfection, particularly for small growth firms. In contrast, proposals to encourage IPOs by use of a larger tick size are likely to be counterproductive.
Keywords: designated market maker, affirmative obligation, information asymmetry, firm value
JEL Classification: D61, D82, G12, G19
Suggested Citation: Suggested Citation