Short Sale Against the Box

This might be a naive question but somehow I am not able to fully understand below from CFAI L3 book i.e. Chapter 11 Section 4.3.1.1

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What I have understood is that investor is long 1 million share and this is his long position. The idea is to monetize this long position. The way described above and what I have understood is that investor will continue to hold his 1 million long position but side by side borrow 1 million shares from broker and sell these borrowed shares in market. Although investor has made a commitment to eventually return the 1 million share back to broker but this commitment is totally hedged because investor is already holding 1 million shares.

I am not expert on the mechanism here which is what is confusing me but after selling the borrowed shares, investor has got $100 million so what is the need to take loan here? I mean this LTV and ability to borrow 99% of the value of stock is not clear. When investor has already got $100 miliion then why would he take loan?

I am sure I must be missing some very basic concept here. Can some please explain with cashflow i.e.

  1. How much goes to investor, how much to broker at T=0 and what is 99% loan and who will get loan proceed and

  2. At the time of unwinding this short position what are the cash flows and how much investor pays and how much broker get and how this loan will be settled.

Thanks

Suppose Party A is long $100 million dollars worth of 1 million ABC stocks ($100 per share). In order to monetize his position, he borrows the same number of shares (1 million) from Party B (broker/dealer) and and sell them in market for $100 each. He now gets $100m cash against his initial long position. This explains the monetization part. Now this $100m can earn risk free rate of return since he has created a risk less position.

Now suppose Party A wants to borrow much more amount from any Bank and he has a lower credit rating such that if he directly goes to a bank for borrowing additional money, he would probably not get high amount as per his needs. Given that he has the above position, assume that he can take around 99% LTV. This means he can additionally borrow $99m against his position. He now have $199m cash in his portfolio.

As far as dividends are concerned, any dividend amount that he will be receiving on his long shares will have to be passed to Party B (lender) and net net he won’t be receiving any dividends.

Also, the interest that he will be paying on his loan amount will get offset by the return he will be getting on the initial $100m dollar. This will offset his net interest payment as well.

All in all, he is at a very better position now compared to situation where he was only long the stock. He was able to get more cash and also take out loan at a much better interest rate as already described above.

Thanks very much Viraj for sparing time and responding to my query.

Dots are indeed joining but I am wondering why would a bank be oblige to give additional loan to Party A based on the flat position. I mean the broker/dealer has claim on the position in the sense that whichever way stock price move, the risk/gain is borne by dealer/broker and PartyA is not exposed to any risk/gain and not even the bank.

Are you saying the safety net the bank assumes for the recovery of their loan is that $100 million diversified position which Party A has created by selling the borrowed stocks? if yes the doesn’t this mean whosoever is holding a well diversified portfolio of $100 million is entitled for 99% LTV because long and short position doesn’t seem to contributing.

Also, during unwinding of the short position, the Party A has to return the 1 million shares because the whole purpose of this discussion was to monetize and not to sale (and inviting capital gain tax). So assuming after X number of years, if Party A liquidates his diversified portfolio to settle the short position with broker then isn’t this $99 million loan become very risk for bank as bank has no surety left to get their loan back unless they force Party A to liquidate his 1 million long position. If this happens that isn’t we have nullified the whole purpose for which we started with i.e. don’t sell stock and still make some money out of the long position.

The actual mechanics of executing and operating such a maneuver is somewhat complicated, but let’s see if I can simplify for you a bit:

The first part, you’re asking why he needs to borrow $99 mil when he has the $100 mil and why is the broker lending that $99 mil. The key here is that the $100 mil that is received from the sale of the borrowed stock has to be invested in a money market instrument. The investor cannot use that $100 mil to buy other securities to diversify the holdings (besides the risk free money market instrument). In order to diversify, he needs to borrow additional money. The broker is willing to lend $99 mil because there’s 1 mil long, 1 mil short, and $100 mil in money market instruments. The long/short positions cancel out, so what the broker is essential doing is lending $99 mil based on the $100 mil in money market instruments.

With respect to unwinding, the investor cannot unwind the short position before he sells the $99 mil worth of securities. He must unwind the diversified positions, getting back $99 mil (+ or - the profits). This amount is then used to pay back the loan from the broker. In terms of the mechanics, this money simply clears up the negative balance on the investor’s account. Once that is cleared up, then he can use the $100 mil that was invested in money market instruments to buy back the 1 mil shares of stock to unwind the short position.

Hopefully this makes sense for you. The actual mechanics aren’t important, but it helps to understand why this strategy makes sense.

Great Will. Thanks for clarifying where $100 million goes and the usage of $99 million and who is lending. It is making sense now. Thanks again.

This is really good. It helped clear up my own confusion as well. Thanks all.

good explanation.

One thing I don’t get is why getting a loan.

Instead of keeping 100m is money market, can’t you just keep 1m in money market and use 99m for building the stock portfolio? what’s the point of borrowing 99m instead of using the money sitting in the money market account?

The lender of the stock generally requires some sort of margin account.

^ what he said. I think our clearing firm requires 40% to be held in margin. CFAI uses the example of needing a “full value” loan because its a global exam and there are different regulations everywhere. It’s much simpler to use an example in their format.

Hi all, thanks for the explanation. It helps a lot, but I have still a question. After receiving the Cash from the sale, the 99MM margin loan is just optional right? I also could invest those 100M received from the Sale directly in a portfolio of diversified stocks, right?

Further I do not understand, where the “money market rate of return” comes from. I can only get this return when im investing the cash proceeds in money market, right? So I would assume this money market return is a minimum return, is this correct?

Last but not least, the whole thing is about circumventing taxes on an outright sale. Why I do not pay taxes on the sale of the borrowed shares? I mean, I sell them on the spot market, right? Are these kind of trades tax-exempt?

Thank you very much in advance