Green Shoes Look Funny

Here is a fun weird paper (and related blog post) about greenshoes, by Patrick Corrigan of Notre Dame. It is titled “Footloose with Green Shoes: Can Underwriters Profit from IPO Underpricing?” We talk about greenshoes from time to time. Here is the way greenshoes are supposed to work. A company does an initial public offering, say of 10 million shares at $40 each. It will give its underwriters an option, called an “overallotment option” or more commonly a “greenshoe,”1 to buy an extra 1.5 million shares (15% of the deal). On the evening that the IPO prices, say it’s a Tuesday, the underwriters will allocate 11.5 million shares to investors, and will buy 10 million shares from the company. The underwriters will be short 1.5 million shares, the shares underlying the greenshoe: They have sold more shares, in the IPO, than they have gotten (so far) from the company.

The next day, Wednesday, the stock will open for trading. Perhaps it will open at $42. Perhaps then it will start dropping. It will reach $40. There is a risk that it will go down further, “breaking” the IPO price of $40. The underwriters will step in. They will start buying stock. They will buy back stock at $40 to stabilize the stock at or near the IPO price. Hopefully the stock will start going up again and everyone—the company that did the IPO, the investors that bought it, the banks—will be happy. If not, though, the banks will keep buying until they have bought 1.5 million shares, the amount of the greenshoe. In that case, the banks have sold 11.5 million shares at $40 on Tuesday night, gotten 10 million shares from the company at $40 on Tuesday night,2 and bought back 1.5 million shares in the open market on Wednesday. They are net flat; they own zero shares and have made zero dollars of trading profits.