Hi, I have some queries regarding the concentrated position which I have looked around the web but couldn’t find the answer.
We have 4 strategies to monetize our positions and the broad idea usually involved removing risk by hedging followed by borrowing against the hedged position to unlock highest LTV.
Question 1: in the example of short sales against the box, is the riskless position created when the investor short the same amount of shares against the shares he long? or is it created when he bought money market instruments with the proceeds from the shares?
Question 2: Do the other strategies, e.g. total return swap, forward conversion with options & equity forward sale contract, also involve using the hedged position to invest in money market instruments which then used as a collateral to unlock the max LTV possible?
Question 3: for the strategy involving forward conversion with options, given it’s a short sale of a synthetic position, the position would have earned risk-free rate as how derivatives are generally priced. Do we also then use the position to invest in money market instrument again?
Question 4: How is the position in total return swap riskless if the underlying is based on a return of an index? There is a risk that the concentrated position return negative yield at the same time that the index also return negative return.
Really appreciate any help here as I have been stuck for some time on this
Q1: You have to short the exact # of shares to have a riskless position, which creates a riskless position. If you are long 100 shares of TESLA and then you short 100 shares, what happens when the shares go up? What happens when the shares go down? Nada…
Q2: You use the position to neutralize to create a riskless position (freezes the asset value), and then you can loan against it cause the lender will have your collateral if you dont pay back.
Q3: No, the investor takes a loan like the other methods.
Q4: The TRS, you pay the appreciation of the stock to the dealer, and the dealer pays you the depreciation of the stock plus some interest rate. Therefore, you have no gain and no loss, so its hedged. Now you can loan away.
I see! Thanks a lot! However, why does the CFAI textbook keep referring to the hedged position as earning money market return? What does that mean? I always get confused if between step 1: hedging the position to make it risk-free and step 2: borrow against the hedged position, is there an intermediate step of buying money market instrument to earn the money market return?
Each hedge results in a moneymakert return. The TRS gets a small return as does the short, as does the forward etc. its just how the math works out in the derivatives.
So none of the strategies involves buying a money market instrument, right? In that case, does that mean money market return and the risk-free rate is the one same thing? Because in CFAI, they use money market return but in a lot of online discussions, they only make reference to the risk-free rate.
I understand for the short positions using derivatives such as the total return swap, forward conversion with options & equity forward sale contract because derivatives pricing is discounted by risk-free rate. But for the short sales, isn’t it just borrowing shares for sales in the market (does not involve any derivative in the process)?
