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The authors analyze the effect of public information on rational investors' incentives to reveal private information during the book building process and their demand for allocations in the IPO. The model generates several new predictions. First, investors require more under pricing to truthfully reveal positive private information in bear markets than in bull markets (the incentive effect). Second, the fraction of positive private signals and of underpriced IPOs is increasing in market returns (the demand effect). Combined, these two effects can explain why IPO under pricing is positively related to pre-issue market returns, consistent with extant evidence. Using a sample of 5,000 U.S. IPOs from 1981-2008, they show that the empirical implications of the model are borne out in the data.
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