5. You have an arrangement with your broker to request 1000 shares of all availa

Question

5. You have an arrangement with your broker to request 1000 shares of all available IPOs. Suppose that 10% of the time, the IPO is “very successful” and appreciates by 100% on the first day, 80% of the time it is “successful” and appreciates by 10%, and 10% of the time it “fails” and falls by 15%.

a) By what amount does the average IPO appreciate the first day; that is, what is the average IPO underpricing?

b) Suppose you expect to receive 50 shares when the IPO is very successful, 200 shares when it is successful, and 1000 shares when it fails. Assume the average IPO price is $15. What is your expected one-day return on your IPO investments?

Explanation / Answer

(a) Average appreciation in IPO = 100%*0.10 + 10%*0.80 + (-15%)*0.10 = 10% + 8% - 1.5% = 16.5%

(b) Average investment = (50*$15)*0.10 + (200*$15)*0.80 +(1000*$15)*0.10 = $3,975

Average gain = (50*$15*100%)*0.10 + (200*$15*10%)*0.80 +(1000*$15*-15%)*0.10 = $90

One day return = $90/$3975 = 2.30%

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