An insight into the signaling role of Sharia status: a case from an emerging IPO market

Abstract

Purpose This study aims to examine the potential of Sharia status as ex ante information to signal the quality of an issuing firm by improving the decision-making process of potential investors when assessing initial public offerings (IPOs) in an environment where information asymmetry is pronounced. Potential investors face challenges in evaluating and determining the true value of IPO issues, which inherently influences their decision-making. Consequently, this results in pronounced price fluctuations in IPO shares, leading to higher underpricing. Design/methodology/approach This study uses a sample of 350 IPOs listed on the Kuala Lumpur Stock Exchange (KLSE) between 2004 and 2021 to examine the signaling role of Sharia-compliance status. A three-model approach is used to ensure that the study's objectives are met. The first model investigates the effect of Sharia status on underpricing to determine whether the main beneficiary of such a signal is the investor or the issuer. The second model examines the effect of Sharia status on investor demand to determine if such a signal influences prospective investors' investment decision-making processes. The third model inspects the effect of Sharia status on investor divergence of beliefs to measure the signal's ability to reduce information asymmetry within the Malaysian IPO market. Findings The Malaysian IPO market relies heavily on the fixed-price mechanism, which exacerbates high information asymmetry, affecting potential investors' behavior, asset price formation and return generation on the first day of listing. The study results indicate that Sharia status does not have any signaling role in the Malaysian IPO market. This is because investors in the Malaysian market are driven by ex ante information that helps unveil relevant information that leads to capital gains. Furthermore, most new issues in the Malaysian IPO market fall under Sharia status, diluting the relevance of such information for prospective investors in determining profitable investments. Practical implications The findings highlight the challenges faced by issuing firms in estimating market demand due to limited premarket insights and the difficulties prospective investors face in identifying the quality of issuing firms. Efforts to provide more information on investor demand can reduce uncertainty and facilitate more informed decision-making. Originality/value This research stands as one of the pioneering efforts to provide an empirical explanation of the potential signaling influence of Sharia status in an emerging IPO market.