I am having trouble understanding how these equity monitization tools help you earn a “risk-free” rate of return. If you make a short sale against the box you borrow the security from the broker (short sale) which offsets your risk, thus a riskless asset. First question: So how do you earn a risk-free rate of return and who is paying you that return? In my broker account right now, if I had 1 shares priced at $100 and then short sold 1 share at $100 how does this combination earn a risk-free rate?
Second question revolves around the “net cost of bowwing is quite low because the interest income earned on the completely hedged stock position greatly offsets the interest expenses associated with the margin loan” How is this true? Are they talking about the “risk-free money market rate earned” offsets the cost of borrowing on the collateral? If I checked correctly, the cost of borrowing from my broker is like 9% and risk-free rate is far below that.
I included the excerpt from the book below for reference:
Because the short sale against the box creates a riskless (i.e., devoid of price risk) position, margin rules typically allow the investor to borrow with a high loan to value (LTV) ratio against the position. It is usually possible to borrow up to 99% of the value of the stock that is hedged, and there are usually no limitations on the use of the proceeds. The proceeds are typically invested in a portfolio of securities and other investments to achieve diversification. 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. - pg 344
(Institute 170)
Institute, CFA. 2015 CFA Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. Wiley Global Finance, 2014-07-14. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
Question 1. So how do you earn a risk-free rate of return and who is paying you that return? In my broker account right now, if I had 1 shares priced at $100 and then short sold 1 share at $100 how does this combination earn a risk-free rate?
A: Once you sell your shares, you take that $100 cash proceeds and go do whatever you want with it. For example invest it, and earn the risk free rate.
Question 2: Second question revolves around the “net cost of bowwing is quite low because the interest income earned on the completely hedged stock position greatly offsets the interest expenses associated with the margin loan” How is this true?
A: Let’s just look at an example. Let’s say I want to raise some cash with my short sale against the box and then go invest somewhere else. We take $100 in stock and since we receive a high LTV, that means our broker will allow us to trade $99 in other securities. (For the purpose of this example, just assume we can trade the full $100 value.) However, to do this, we need a margin account. Now the margin required will be substantially less than the securities we may go purchase. Let’s say the margin requirement for the security we are looking at is 10%. That means we would need to pay margin interest on 10% of the $100. So, even if the marign rate is higher than the amount we can generate by investing the $99, we are still ahead. (Say you pay 5% on a margin loan @ 10, that is .50 but, you generate 1% on the full 1. Well you can see that you receive a net interest amount of .50).