IPO Underpricing The Woods Co. and the Mickelson Co. have both announced IPOs at

Question

IPO Underpricing

The Woods Co. and the Mickelson Co. have both announced IPOs at $40 per share. One of these is undervalued by $11, and the other is overvalued by $3, but you have no way of knowing which is which. You plan to buy 1,000 shares of each issue. If an issue is underpriced, it will be rationed, and only half your order will be filled. If you could get 1,000 shares in Woods and 1,00 shares in Mickelson, what would your profit be? What profit do you actually expect? What principle have you illustrated?

Explanation / Answer

a. Total profit = 1000*11 - 1000*3 = $8000

b. Expected profit = 500*11 - 1000*3 (Since only half the shares will be allotted)

= $2500

c. The principle illustrated is that of the Winner's curse. Due to incomplete information, there is a tendency of the investor to overpay for the shares and exceed the intrinsic price of the shares.

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