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I present a fully-rational symmetric-information model of an IPO,
and a dynamic imperfectly competitive model of trading in the IPO
aftermarket. The model helps to explain IPO underpricing,
underperformance, and why share allocations favor large
institutional investors. In the model, underwriters need to sell a
fixed number of shares at the IPO or in the aftermarket. To
maximize revenue and avoid selling into the aftermarket where they
can be exploited by large investors, underwriters distort share
allocations towards investors with market power, and set the IPO
offer price below the aftermarket trading price. Large investors
who receive IPO share allocations sell them slowly afterwards to
reduce their trade's price-impact. This curtails the shares that
are available to small price-taking investors, causing them to bid
up prices and bid down returns. In some simulations, the distorted
share allocations and slow unwinding behavior generate post-IPO
return underperformance that persists for several years.
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