MN10403
1. Shortselling:
= one borrows the asset from a third party and then sells it on to the buyer.
MECHANICS: We want to sell the overpriced stock. To do this, we need to borrow the stock from someone
who has an interest to lend it to us, and we then need to sell it to someone who has an interest to buy it.
This will give us a positive cash balance, and it will also give us an obligation to the lender (a short position).
We will then await the price drop and will try to liquidate our short position, hoping to keep a positive cash
balance.
The maximum gain is bounded by the initial price from the morning, minus the borrowing fee.
The maximum loss is unbounded. The higher the new price at 3pm, the costlier it becomes for us to buy back
the share. If goes up and up, so do your losses!
Gains are bounded by the initial price, losses are unbounded. Short-selling is very risky. Getting your
shortselling wrong hurts.
POSITION Current investor – Short-seller Investor interested
lender A (borrower) B in company C
At start Long in share X
B borrow X share Long in borrowing Long in share X
from A short in borrowing
B sells X share to Long in borrowing short in X Long-position in
C short in borrowing share X
B buys back X Long in borrowing Long in cash Short in X
shares from C long in share X
short in borrowing
B returns X shares Long in share X >> NET EFFECT:
to A increase in cash
balance, complete
cancellation of all
positions in shares or
borrowing
Dividends payment during borrowing of share: If XYZ lends us one share of ABC, they either accept that they
lose out on any dividends whilst the share is away, or they require the borrower KLM to compensate for
those payments. That second scenario is more common, as it means that the lender XYZ can treat
themselves as if they still owned the share.
BP’s actual dividend payment associated with share No 375 goes to E, the new owner. But C still wants to be
in a cash-flow position that is exactly the same as that of the true owner of the share. The borrowing contract
makes this duplication possible, by requiring the borrower of the share, A, to pay C any such dividends if they
happen to occur during the borrowing period.
Calling share back:
(1) borrower returns anytime he wants: borrower KLM can try to go through periods of sharp price rises
without having to buy the share at those high prices. A would do that in the hope that the prices ultimately
come down. The borrrowing fees will of course accumulate and may require KLM to liquidate his short
position at some point.
(2) lender takes back anytime: lender XYZ can force borrower KLM to return the share if the price is very
high, perhaps in order to sell the share herself. If the contract allows this call-back option, the borrower is
very exposed to sudden high price rises, as there is no way to avoid heavy losses if the owner makes the call
back in those circumstances. Many borrowing contracts for assets will have an element of scenario (2),
making short-selling very risky for the short-seller.
, 2. Volkswagen 2008:
When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their
positions. This rush creates a high demand for the stock quickly driving up the price even further.
This phenomenon is known as a short squeeze.
Volkswagen:
State owns 20% of VW shares. Porsche family owns some 40%, plus secretly another 35% via call options on
VW shares. The public only knows of the 40% and does not know of the 35%, and thus the public thinks that
40% of all shares are free to trade (100 in total, minus 20 state, minus 40 Porsche). Hedge funds too are
unaware of the secret 35%. Hedge funds think that VW shares are vastly over-priced and short-sell VW
shares on a large scale.
Volume of short-sales ca 11% of all shares. If 40% of all shares were free, this would be a high proportion but
still feasible. But in reality 35% are already in possession of Porsche, so only 5% of all shares are free, less
than the volume of short sales.
Then Porsche publicises its ownership of the full 75% and their intention to keep them. Now it is clear that
there aren't enough shares left for the hedge funds.
-> instant short squeeze
-> Short sellers desperate to close their positions paid as much as 1,005 euros a share during the session
following Sunday's news that there was less than 6 percent of VW voting stock still floating in the market.
-> Volkswagen's voting stock was worth 296 billion euros ($370 billion), or more than the $343 billion market
capitalization of Exxon Mobil (XOM.N). VW shares later closed trading on Tuesday up 82 percent at 945
euros.
-> Around 12.8 percent of Volkswagen's entire market capitalization was on loan as of October 25, compared
with an average 5 percent for all DAX stocks.
-> Several leading funds are estimated to have lost up to €5bn when their short-selling turned toxic, with the
total losses calculated at anything between €20bn and €30bn.
-> Germany's premier stock index, the DAX, was changed to cut VW's proportion in it. That allowed index
funds to sell stock, adding to the supply of shares, and VW's shares lost part of their gains.
3. Arbitrage bond- bank:
Arbitrage: include exchanges where your need to pay money to one of your trading partners, a cash
outflow, but that money will have to come from some other transactions of yours that produce the
corresponding cash inflows at the same time.
At any one point in time, your net cashflows (the total of your cash outflows minus the total of your cash
inflows at the given point in time) should either be positive or zero. The net flows that are positive are your
arbitrage profit.
The temporal sequence of bond-bank is as follows:
(1) In February 2017, take out a loan for 89 pounds, with the bank, at an agreed annual interest rate of 10%.
(2) Immediately upon receiving the loan, still in February 2017, use these 89 pounds to buy one share of the
bond, promising 100 pounds payoff next year.
(3) Keep the bond and the loan during the year.
(4) In February 2018, claim the 100 pounds payoff from the bond issuer.
(5) Immediately after receiving these payoffs, go to the bank and pay back your loan with interest, which is
97.90 pounds.
(6) Keep the remaining 2.10 pounds as a profit.
➔ we combine the more attractive way of transferring money from 2017 to 2018 (For a surplus unit, to
transfer money from the present to the future, we either buy the bond or we deposit money with the
bank. Two different routes for the same purpose, namely − → +. We can see that from the viewpoint
of the surplus unit, the bond route is more attractive than the bank route, since the bond’s 100 is a
higher payoff than the bank’s 97.90, coming from the same initial investment of 89) with the more
attractive way of transferring money from 2018 to 2017 (For a firm that is a deficit unit, to transfer
money from the future to the present, the firm either issues the bond or it takes a loan from the
1. Shortselling:
= one borrows the asset from a third party and then sells it on to the buyer.
MECHANICS: We want to sell the overpriced stock. To do this, we need to borrow the stock from someone
who has an interest to lend it to us, and we then need to sell it to someone who has an interest to buy it.
This will give us a positive cash balance, and it will also give us an obligation to the lender (a short position).
We will then await the price drop and will try to liquidate our short position, hoping to keep a positive cash
balance.
The maximum gain is bounded by the initial price from the morning, minus the borrowing fee.
The maximum loss is unbounded. The higher the new price at 3pm, the costlier it becomes for us to buy back
the share. If goes up and up, so do your losses!
Gains are bounded by the initial price, losses are unbounded. Short-selling is very risky. Getting your
shortselling wrong hurts.
POSITION Current investor – Short-seller Investor interested
lender A (borrower) B in company C
At start Long in share X
B borrow X share Long in borrowing Long in share X
from A short in borrowing
B sells X share to Long in borrowing short in X Long-position in
C short in borrowing share X
B buys back X Long in borrowing Long in cash Short in X
shares from C long in share X
short in borrowing
B returns X shares Long in share X >> NET EFFECT:
to A increase in cash
balance, complete
cancellation of all
positions in shares or
borrowing
Dividends payment during borrowing of share: If XYZ lends us one share of ABC, they either accept that they
lose out on any dividends whilst the share is away, or they require the borrower KLM to compensate for
those payments. That second scenario is more common, as it means that the lender XYZ can treat
themselves as if they still owned the share.
BP’s actual dividend payment associated with share No 375 goes to E, the new owner. But C still wants to be
in a cash-flow position that is exactly the same as that of the true owner of the share. The borrowing contract
makes this duplication possible, by requiring the borrower of the share, A, to pay C any such dividends if they
happen to occur during the borrowing period.
Calling share back:
(1) borrower returns anytime he wants: borrower KLM can try to go through periods of sharp price rises
without having to buy the share at those high prices. A would do that in the hope that the prices ultimately
come down. The borrrowing fees will of course accumulate and may require KLM to liquidate his short
position at some point.
(2) lender takes back anytime: lender XYZ can force borrower KLM to return the share if the price is very
high, perhaps in order to sell the share herself. If the contract allows this call-back option, the borrower is
very exposed to sudden high price rises, as there is no way to avoid heavy losses if the owner makes the call
back in those circumstances. Many borrowing contracts for assets will have an element of scenario (2),
making short-selling very risky for the short-seller.
, 2. Volkswagen 2008:
When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their
positions. This rush creates a high demand for the stock quickly driving up the price even further.
This phenomenon is known as a short squeeze.
Volkswagen:
State owns 20% of VW shares. Porsche family owns some 40%, plus secretly another 35% via call options on
VW shares. The public only knows of the 40% and does not know of the 35%, and thus the public thinks that
40% of all shares are free to trade (100 in total, minus 20 state, minus 40 Porsche). Hedge funds too are
unaware of the secret 35%. Hedge funds think that VW shares are vastly over-priced and short-sell VW
shares on a large scale.
Volume of short-sales ca 11% of all shares. If 40% of all shares were free, this would be a high proportion but
still feasible. But in reality 35% are already in possession of Porsche, so only 5% of all shares are free, less
than the volume of short sales.
Then Porsche publicises its ownership of the full 75% and their intention to keep them. Now it is clear that
there aren't enough shares left for the hedge funds.
-> instant short squeeze
-> Short sellers desperate to close their positions paid as much as 1,005 euros a share during the session
following Sunday's news that there was less than 6 percent of VW voting stock still floating in the market.
-> Volkswagen's voting stock was worth 296 billion euros ($370 billion), or more than the $343 billion market
capitalization of Exxon Mobil (XOM.N). VW shares later closed trading on Tuesday up 82 percent at 945
euros.
-> Around 12.8 percent of Volkswagen's entire market capitalization was on loan as of October 25, compared
with an average 5 percent for all DAX stocks.
-> Several leading funds are estimated to have lost up to €5bn when their short-selling turned toxic, with the
total losses calculated at anything between €20bn and €30bn.
-> Germany's premier stock index, the DAX, was changed to cut VW's proportion in it. That allowed index
funds to sell stock, adding to the supply of shares, and VW's shares lost part of their gains.
3. Arbitrage bond- bank:
Arbitrage: include exchanges where your need to pay money to one of your trading partners, a cash
outflow, but that money will have to come from some other transactions of yours that produce the
corresponding cash inflows at the same time.
At any one point in time, your net cashflows (the total of your cash outflows minus the total of your cash
inflows at the given point in time) should either be positive or zero. The net flows that are positive are your
arbitrage profit.
The temporal sequence of bond-bank is as follows:
(1) In February 2017, take out a loan for 89 pounds, with the bank, at an agreed annual interest rate of 10%.
(2) Immediately upon receiving the loan, still in February 2017, use these 89 pounds to buy one share of the
bond, promising 100 pounds payoff next year.
(3) Keep the bond and the loan during the year.
(4) In February 2018, claim the 100 pounds payoff from the bond issuer.
(5) Immediately after receiving these payoffs, go to the bank and pay back your loan with interest, which is
97.90 pounds.
(6) Keep the remaining 2.10 pounds as a profit.
➔ we combine the more attractive way of transferring money from 2017 to 2018 (For a surplus unit, to
transfer money from the present to the future, we either buy the bond or we deposit money with the
bank. Two different routes for the same purpose, namely − → +. We can see that from the viewpoint
of the surplus unit, the bond route is more attractive than the bank route, since the bond’s 100 is a
higher payoff than the bank’s 97.90, coming from the same initial investment of 89) with the more
attractive way of transferring money from 2018 to 2017 (For a firm that is a deficit unit, to transfer
money from the future to the present, the firm either issues the bond or it takes a loan from the
