The fact that IPOs are widely underpriced on average may seem puzzling: it suggests that a simple strategy of systematically buying stocks in IPOs would generate large expected profits. One reason why this may not be true is called adverse selection and we will talk about it more extensively later. Here is a first illustration. Suppose the first-day return of IPOs is 40% half of the time (underpricing) and -15% half of the time (overpricing), so that there is underpricing on average. You ask for 1,000 worth of stocks in every IPO and sell at the end of the first trading day. (a) If you always obtain the stocks you ask for, what is your expected profit per IPO? (b) Suppose now that there are investors with better information than you in the market. Unlike you, these sophisticated investors can distinguish between

under- and overpriced IPOs and therefore only bid when the IPO is under- priced. As a result, underpriced IPOs are oversubscribed (demand is higher

than number of stocks offered) and you get fewer stocks than you asked for, say for a value of 300. Since sophisticated investors do not bid in IPOs they know to be overpriced, these IPOs are not oversubscribed and you still get 1,000 worth of stocks. What is your expected profit per IPO?