Question

The Bert Corp. and Ernie, Inc., have both announced IPOs. You place an order for 1,150 shares of each IPO. One of the IPOs is underpriced by $18.00 and the other is overpriced by $6.50. You will receive all of the shares you ordered of the overpriced IPO, but only one-half of the shares you ordered of the underpriced IPO. What profit do you expect?

Answer 1

In this case, in order to calculate the expected profit, we need to treat amount by which the shares are underpriced as profit because eventually when the markets achieve equilibrium in future our investment will rise by the underpriced while the amount overpriced is to be considered as a loss because when the markets achieve equilibrium our investment will downfall by the overpriced amount.

Therefore,.

Number of overpriced shares received = 1150

Amount by which shares are overpriced = $6.50

Therefore, total amount in overpriced shares= Number of shares * Overpricing per share (Loss) = 1150 * 6.50 = $7475

Number of underpriced shares received = 1150/2 = 575 shares

Amount by which shares are underpriced = $18

Total amount invested in underpriced shares = Number of shares Amount by which shares are underpriced (profit)= 575*18 = $10350

Total expected profit = Profit in underpriced shares - Loss in overpriced shares  

Total expected profit = $10350 - $7475 = $2875