Saturday, November 12, 2005

      Winner's Curse

Winner's Curse: A tendency for the winning bid in an auction to exceed the intrinsic value of the item won.

The problem of the winner's curse occurs during any auction process in which bidders must estimate the true or final value of a desired good. Generally, bidders are considered to be risk averse, and the average bid is expected to be lower than the final value. However, due to estimation errors, the winning bid is usually much higher because the highest overestimation made by any of the bidders will win the auction.

The significance of this theory is most evident in IPO pricing schemes. Because this observation contradicts the common assumption of rational investors, it allows underwriters to price new issues differently.


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