Question

Smart Smith Ltd, and Dumb Jack Ltd. have both announced IPOs at $40 per share. One of them is underpriced by $11 and the other is overpriced by $3. However, you don't know which is underpriced and which is overpriced so you plan to bid for 1,000 shares for each IPO. Required: (a) What would be your profit if you could get 1,000 shares in both IPOs? (2 marks) (b) If an issue is underpriced, the offer will be rationed and only half of your order will be filled. What will be your profit in this case? (2 marks) (c) Comparing the answers to part (a) and part (b), what principle is illustrated? (1 mark)

Answer 1

Solution to a

profit per share on underpriced stock = $11 . The loss per share on overpriced share = $3

Hence total profit = ($11*1000) - ($3 * 1000) = $8000

Solution to b

you will receive only 1,000/2 shared on the underpriced share.

Hence, the profit will be ($11*500) - ($3 * 1000) = $2,500

The underpriced issue had to be rationed as there was more demand for it. Investors may have realised that the issue is underpriced, which would have led to a higher demand, leading to an over-subscription. As a result, the company would have had to ration the shares among investors.

This goes to show that if there is any discrepancy or arbitrage in share prices, many investors will try to take advantage of it. The increased demand upon realisation of the arbitrage will eat up the arbitrage eventually.