PART 2: VALUATION, RISK AND RETURNelse. When investors borrow a security and sell it, they are selling short. In some markets, or in periods
of substantial financial market instability, short selling is banned. In these cases, an extra restriction is
imposed on the portfolio weights; each individual weight must be greater than or equal to zero, and less
than or equal to one. Here’s how shorting works.
Consider two assets in the market, Rocket.com and BricksNMortar Inc. Both shares currently sell
for $10 and pay no dividends. You are optimistic about Rocket’s prospects, and you expect its return next
year to be 25%. In contrast, you believe that BricksNMortar will earn just 5%. You have $1,000 to invest,
but you would like to invest more than that in Rocket.com. To do this, you phone a friend who owns 50
shares of BricksNMortar and persuade him to let you borrow the shares by promising that you’ll return
them in one year. Once you receive the shares, you sell them in the market, immediately raising $500
(50 shares × $10 per share). Next, you combine those funds with your own money and purchase $1,500
(150 shares) of Rocket.com. Your portfolio expected return looks like this:E(rp) = (–0.5)(5%) + (1.5)(25%) = 35%
In this equation, the weight invested in Rocket.com equals 1.5 ($1,500 ÷ $1,000), or 150% of your
total wealth. You can invest more than 100% of your wealth (that is, more than $1,000) because you
borrowed from someone else. The weight invested in BricksNMortar equals –0.5 because you took out
a $500 loan equivalent to half your wealth. If you are right and BricksNMortar shares go up from $10 to
$10.50 during the year (an increase of 5%), then you will effectively pay your friend 5% interest when
you repurchase the BricksNMortar shares and return them next year. This loan will be very profitable if
Rocket.com shares increase as rapidly as you expect. For example, in one year’s time, if BricksNMortar
sells for $10.50 (up 5%) and Rocket.com sells for $12.50 (up 25%), your position will look like this:Beginning of year
Initial investment $1,000
Borrowed funds 500 (50 shares @ $10)
Rocket shares $1,500 (150 shares @ $10)
End of year
Sell Rocket.com shares $1,875 (150 shares @ $12.50)
Return borrowed shares – 525 (50 shares @ $10.50)
Net cash earned $1,350
Rate of return = ($1,350 – $1,000)/$1,000 = 0.35 = 35%Notice that the expected return on this portfolio exceeds the expected return of either share in
the portfolio. When investors take a short position in one asset to invest more in another asset, they
are using financial leverage. As is noted in Chapter 13, leverage magnifies expected returns, but it also
increases risk. This is one of the reasons why short selling is viewed as risky by some market regulators.
For example, many markets that usually allow short selling restricted it during the global credit crisis that
began in 2008. These markets included the UK, US and Australia. In Australia, restrictions were more
stringent, with a ban on all short selling for a period of time. The restrictions made it very difficult for
many hedge funds to survive, since many relied on short selling to make profits. The global attrition in
the number of viable hedge funds in 2009 is commonly attributed to these restrictions.See the concept explained
step by step on the
CourseMate website.SMART
CONCEPTS
selling short
Borrowing a security and
selling it for cash at the
current market price. A short
seller hopes that either: (1) the
price of the security sold short
will fall; or (2) the return on
the security sold short will be
lower than the return on the
asset in which the proceeds
from the short sale were
invested