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The Speith Co. and the Reed Co. have both announced IPOs at $50 per share. One...

The Speith Co. and the Reed Co. have both announced IPOs at $50 per share. One of these is undervalued by $9 and the other is overvalued by $2, but you have no way of knowing which is which. You plan on buying 400 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 400 shares in Speith and 400 shares in Reed, what would your profit be? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) What profit do you actually expect? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

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Answer #1

If you receive 400 shares of each, the profit is:

Profit = 400($9) – 400($2)

Profit = $2,800

Since you will only receive one-half of the shares of the oversubscribed issue, your profit will be:

Expected profit = 200($9) – 400($2)

Expected profit = $1,000

This is an example of the winner’s curse.

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