The effect of volatility estimates in the valuation of underwritten rights issues

Abstract

The focus of this study is the effect of volatility estimates in the valuation of underwritten rights issues. Previous studies on the valuation of rights issues found that underwriters overpriced the risk of underwriting that they provide to companies for rights issues. This paper, in its examination of Australian rights issues from 1987 to 1993, provides evidence that the degree of overpricing, if any, is dependent on the volatility that is used in the option model to value the underwritten rights issue. This paper shows that if the volatility is adjusted for the problem of thin trading, then the volatility in the pre-announcement period is significantly different from the volatility in the underwriting period. If previous studies used a pre-announcement volatility as the volatility in the underwriting period, the model used for valuation would be underpricing the actual underwritten rights issue or overpricing the returns earned by the underwriters. This result of underpricing of the option model when a historical volatility was used is consistent with that found by other researchers with regard to the valuation of exchange-traded options using a historical volatility estimate.