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Interest Income (Money Market ROR) on a short sale against the box

“Because the long and short positions together constitute a riskless position, the investor will earn a money market rate of return on the $100 million position”

“The net cost of borrowing through a short sale against the box is quite low because the interest income earned on the completely hedged stock position greatly offsets the interest expense associated with the margin loan.”

The above two statements in Section 4.3.1.1 reference the income one can earn on a short sale against the box. I understand how the equity position is transformed into a riskless asset and that there will be interest expense on the margin loan and borrowing costs. What I do not understand is how the riskless position generates a money market ROR absent borrowing against it. Furthermore, there is no mention of the cost to borrow the shares.

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When you sell the stock short you get cash, that you invest at the risk-free rate.

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Okay then the decision to invest the cash at the risk free rate is implied, which I can understand. The problem then becomes that the original statement is that the purpose of the cash proceeds is to ”invest in a portfolio of securities and other investments to achieve diversification.”

That would disallow them from being used to achieve a risk-free ROR or “money market” return that would cover the margin lending costs and offset the share borrowing costs.

If you generate $10mm from a short sale ignoring share borrowing costs, you cannot simultaneously invest the $10mm cash proceeds in a money market AND invest them in a “portfolio of securities and other investments to achieve diversification.” Do you see where the confusion arises? It seems the reading is double counting the cash proceeds from the short sale

This was explained nicely in a different post. Using your example, the $10m short proceeds would be invested in a money market instrument earning the risk free rate. This fully hedged position can then be used as collateral for a loan (90%+ LTV) and the loan proceeds can be invested in a diversified portfolio. The interest earned on the money market security, in theory, should offset the interest payment on the loan.

This is the case with all of the single-stock monetization strategies used in the text (short sale, total return swap, forward conversion with options - AKA equity collar, and an equity forward sale). The idea is to fully hedge the position and then secure a loan against it. 

The goal of this is to diversify without trigging tax. In the real world (at least in Canada & the US) you have to be careful of a “synthetic sale” for tax purposes. This is not in the curriculum, but in essence if you fully hedge the long position it can be viewed as a sale for tax purposes. To avoid this, you would generally hedge ~90% of your position thereby maintaining an element of risk and avoiding a synthetic sale in the eyes of the tax man. 

Okay that helps a lot. To summarize:

Step 1: Borrow Shares

Step 2: Sell shares short

Step 3: Invest proceeds in Money Market

Step 4: Borrow Money against risk-less position (only 90% LTV to avoid synthetic sale)

( Money Market returns offset cost to borrow against risk-less position)

Step 5: Invest proceeds in diversified portfolio

Few clean up questions here:

The reading ignores the cost of borrowing shares. In fact, I was initially confused because I though the phrase, “The net cost of borrowing through a short sale against the box is quite low…” referred to the cost to borrow shares. I understand now to what the “borrow net costs” refer to; however, it would be nice in practice to understand the impact of the cost of borrowing shares (it’s obviously a nonzero number) 

Second, why go through the trouble of investing cash proceeds in a money market then borrowing against it? Credit risk will cause borrowing costs to exceed lending proceeds. Why not just invest the cash directly into aa portfolio of diversified assets?

brickbreaker wrote:
Okay that helps a lot. To summarize:

Step 1: Borrow Shares

Step 2: Sell shares short

Step 3: Invest proceeds in Money Market

Step 4: Borrow Money against risk-less position (only 90% LTV to avoid synthetic sale)

( Money Market returns offset cost to borrow against risk-less position)

Step 5: Invest proceeds in diversified portfolio

Few clean up questions here:

The reading ignores the cost of borrowing shares. In fact, I was initially confused because I though the phrase, “The net cost of borrowing through a short sale against the box is quite low…” referred to the cost to borrow shares. I understand now to what the “borrow net costs” refer to; however, it would be nice in practice to understand the impact of the cost of borrowing shares (it’s obviously a nonzero number)

I don’t have firsthand experience with this, but I’m given to believe that the cost to borrow shares is quite low.

brickbreaker wrote:
Second, why go through the trouble of investing cash proceeds in a money market then borrowing against it? Credit risk will cause borrowing costs to exceed lending proceeds. Why not just invest the cash directly into aa portfolio of diversified assets?

Generally, when you sell shares short you have to leave the proceeds (or, at least, a sizable portion thereof) in a margin account as surety.  So, in short, you don’t really have much choice.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

awesome. ty!

yw!  mp!

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

Maybe for institutional shorting is different, but in my TDAmertrade account, margin use gets expensive, and definitely costs more than money market. I tend not to want to hold short positions for too long due to cost.

Base rate of 9.5% and the client rate is based on size of margin account.

Dollar Range

Above/Below Base Rate

Above $999,999 -1.50%

$250,000 - $999,999 -0.75%

$100,000 - $249,999 -0.50%

$50,000 - $99,999 -0.25%

$25,000 - $49,999 +0.75%

$10,000 - $24,999 +1.00%

Under $10,000 +1.25%