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greater timing flexibility. These results hold up after adjusting for the self-selection bias
highlighted in the earlyDenis (1991)study. They also separately study universal shelf
issues that result in an SEO. They note that shelf issues create valuable options that be-
come more valuable under more volatile market conditions.Bethel and Krigman (2004)
re-examine the question of reduced due diligence in shelf issues. They report that high
asymmetric information issuers experience high discounts from using the shelf registra-
tion mechanism, which explains why this mechanism isn’t more widely employed.
3.9. Over-allotment options, warrants and other direct expenses
Over-allotment options. A second component of underwriter compensation is an over-
allotment option, which is a warrant to buy an additional 10–15 percent of the offering
at the same price as the SEO/IPO. The typical over-allotment option has a maximum
life of 30 days. Underwriters can use these options to lower their risk exposure in a firm-
commitment underwriting contract. This underwriter hedging activity in the IPO market
is the focus of a study byAggarwal (2000). She finds that underwriters exercise over-
allotment options to cover short positions created by underwriters over-selling securities
in public offerings when the after-market stock price rises relative to the offering price.
She also finds that underwriters buy shares in the after-market to cover short positions
when the stock price falls to the offering price or lower.
Over-allotment options can alternatively be viewed as valuable short term warrants
held by underwriters that allow them to purchase up to an additional 15 percent of an
undervalued offering at the underwriter’s discount from the public offer price. Little
research is available on the value of these options, with the exception of an early study
byHansen, Fuller and Janjigian (1987), who examine over-allotment options in SEOs
of industrial firms. They estimated the value of the typical over-allotment option to be 1
percent of the offer’s gross proceeds. They also report that about half their offer sample
had over-allotment options. Using a logit model, they find that over-allotment options
are more frequent in offers with smaller dollar size, larger relative size, greater stock and
market return variances and more retail oriented (strong broker system) underwriters.
In the IPO market,Lee et al. (1996)report that virtually all U.S. issues include over-
allotment options and nearly all are for 15 percent of the original issue size and are
issued at-the-money. Further, about 60 percent of the options are either partially or fully
exercised, with the vast majority fully exercised.
Warrants as additional underwriter compensation. Several studies byNg and Smith
(1996)andDunbar (1995)investigate the use and importance of warrants as an ad-
ditional element of underwriter compensation in SEOs. Controlling for the selectivity
imbedded in the choice of using warrants as added underwriter compensation with a
logit model, they find that warrant use reduces the overall flotation costs of SEOs. Since
warrants are less valuable when the underlying stock is overvalued, the credibility of
smaller and less well known underwriters is increased when they accept warrants as
compensation. This can reassure investors who could otherwise question the credibility
of less reputable underwriters, thus lowering the average SEO underpricing necessary
to sell these issues.