SHORT SELLINGAN IMPORTANT TOOL FOR PRICE DISCOVERY ANDLIQUIDITY IN THE FINANCIAL MARKETPLACE
Short Selling2ContentsExecutive SummaryWhat Is Short Selling?Why Do Traders Sell ShortHow Does Short Selling InfluencePric...
What is Short Selling?3Short selling can be used:• To profit from an anticipated downward price movementand / or• To hedge...
What is Short Selling?4TimePriceInvestor exits short position andmakes a profitInvestor believes stock, fromCompany X, is ...
Why Do Traders Sell Short?5A. Risk management for hedging long positions and managing portfolio riskB. Increasing efficien...
How Does Short Selling Influence Prices?6Markets function most efficiently when the current trading price of an asset refl...
How Does Short Selling Influence Prices?7If short selling did not exist, prices would predominantly reflect only positive ...
Three Common Short Selling Platforms8Three common platforms where short selling happens:Investors borrowshares of a compan...
How Does Shorting Work in the Stock Market?9There are two main reasons equity investors employ short selling:• To act on t...
Short Selling in the Commodities Marketplace10The most common application of short selling in the commodities marketplace ...
Short Selling in the Commodities Marketplace11While there is a popular criticism that short selling impacts the price of a...
Short Selling in the Commodities Marketplace12• Weather events• Political instability• Global economic performanceConsumer...
Short Selling and Sovereign / Corporate DebtFor decades, governments have sold bonds to investors to help finance immediat...
Short Selling Restrictions14The Regulation of Short Selling:*Source The effects of short-selling public disclosure regimes...
Effects of Short Selling BansIn recent years, regulators have, specifically in the European Union, implemented temporary b...
Short Selling RestrictionsCurrently there are a number of short selling restrictions in place in the E. U.:On November 1, ...
ReferencesU.S. Regulatory Agencies:Securities and Exchange Commission (SEC)www.sec.govCommodity Futures Trading Commission...
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Short Selling: An Important Tool for Price Discovery and Liquidity in the Financial Marketplace

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The new presentation gives users valuable information about how hedge funds and other investors participate in the marketplace through short selling.

As the presentation describes, short selling generally means borrowing an asset (a security/stock, commodity futures contract, and corporate or sovereign bond) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. The short seller then closes out the short position by buying equivalent securities on the open market, or by using an identical security it already owned, and returning the borrowed security to the lender.

As many news stories highlight short selling as a negative force in our markets, the new presentation explains how short selling can be a way for investors to communicate their view on the price of an asset. Short selling also provides many other critical benefits to investors, including:

• Risk management for hedging long positions and managing portfolio risk
• Increasing efficiency in the marketplace because the transactions inform the market with their evaluation of future stock, bond, or commodity price performance
• Lowering overpriced securities by encouraging better price discovery
• Providing liquidity by increasing the number of potential sellers in the market

Learn more about the global hedge fund industry at: www.hedgefundfundamentals.com.

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Short Selling: An Important Tool for Price Discovery and Liquidity in the Financial Marketplace

  1. 1. SHORT SELLINGAN IMPORTANT TOOL FOR PRICE DISCOVERY ANDLIQUIDITY IN THE FINANCIAL MARKETPLACE
  2. 2. Short Selling2ContentsExecutive SummaryWhat Is Short Selling?Why Do Traders Sell ShortHow Does Short Selling InfluencePrices?Three Common Short SellingPlatformsHow Does Shorting Work In TheStock Market?Short Selling In The CommoditiesMarketplaceShort Selling AndSovereign/Corporate DebtShort Selling RestrictionsEffects Of Short Selling BansShort Selling RestrictionsReferences23-456-78910-121314151617Short selling often receives considerable attention inthe financial media.Misconceptions have taken root in news reportsleading to coverage that is often critical andincomplete.This presentation offers a brief overview of the roleshort selling plays in the marketplace, as viewedthrough three distinct trading platforms – equities,commodities, and sovereign debt.Executive Summary:Equities/StocksSovereignDebtCommodities
  3. 3. What is Short Selling?3Short selling can be used:• To profit from an anticipated downward price movementand / or• To hedge the risk of a long position in the same security,in a related security, or other type of long exposureSources: MFA Glossary; http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm.Short selling generally means borrowing an asset (a security /stock, commodity futurescontract, and corporate or sovereign bond) from a broker and selling it, with the understandingthat it must later be bought back (hopefully at a lower price) and returned to the broker. *The short seller closes out the short position by buying equivalent securities on the openmarket, or by using an identical security it already owned, and returning the borrowed securityto the lender.
  4. 4. What is Short Selling?4TimePriceInvestor exits short position andmakes a profitInvestor believes stock, fromCompany X, is overpricedand takes on „short-position‟*Over time, Company X‟s stockvalue does decline$15$30Price Difference X Number of Shares = ProfitProfitShort selling is a trading strategy investors use when they believe that shares of a particularstock, bond or commodity, is overpriced.$0
  5. 5. Why Do Traders Sell Short?5A. Risk management for hedging long positions and managing portfolio riskB. Increasing efficiency in the marketplace because their transactions inform themarket with their evaluation of future stock, bond or commodity price performance.C. Lowering overpriced securities by encouraging better price discoveryD. Providing liquidity by increasing the number of potential sellers in the market**Source: http://www.fsa.gov.uk/pubs/discussion/dp09_01.pdfSome believe short selling is purely driven by profit motive and that it has little or no value inthe broader financial markets.While the potential for profit can sometimes be an incentive to enter into various tradingpositions.There are many other more critical benefits that short selling provides to investors including:
  6. 6. How Does Short Selling Influence Prices?6Markets function most efficiently when the current trading price of an asset reflectsan accurate estimate of an asset‟s worth.Short selling is one useful avenue for investors to communicate their viewon the price of an asset.
  7. 7. How Does Short Selling Influence Prices?7If short selling did not exist, prices would predominantly reflect only positive views, driven bybuyers in the market, thus pushing prices higher through their demand..Those artificially inflated prices would not represent the true, efficient trading price ofthe asset since they would be created with incomplete information and omittingnegative viewpoints of the asset.
  8. 8. Three Common Short Selling Platforms8Three common platforms where short selling happens:Investors borrowshares of a companywith an understandingthat they will have tobe returned at a setdate in time in thefutureInvestors express theirshort view by buying creditdefault swaps to protectagainst downwardmovement in the price ofsovereign and/or corporatedebtInvestors contract tosell a commodity at alater date with theexpectation that thecommodity‟s price willbe lower at that timeEquities / Stocks Commodities Sovereign / CorporateDebt
  9. 9. How Does Shorting Work in the Stock Market?9There are two main reasons equity investors employ short selling:• To act on their viewpoint that a particular stock is overpriced / over-valued• Example – if an investor believed that Company X‟s customer base was shiftingaway from them and anticipated lower earnings later that year, he/she couldput on a short sale reflecting the expectation of a decline in share value.• To provide balance in their portfolio and offset (or hedge) a long investmentposition• Example – An investor holds 100 shares of Technology Company A stock in along position. In order to provide balance to his portfolio – and protect againstvolatility and risk – the investor could borrow 100 shares of TechnologyCompany B stock (another company in the same sector) to offset, or hedge, hislong investment position.The Equities Trade:
  10. 10. Short Selling in the Commodities Marketplace10The most common application of short selling in the commodities marketplace is as a hedge to offsetlonger investment positions.In these trades, fund managers – Commodity Trading Advisors (CTAs) -- use hedges to manage riskand volatility in the marketplace.The Commodities Trade:Sally, a Chief Investment Officer for a corporatepension plan, is worried about inflation risk.So, she invests in gold to offset the risk that her portfolio willdecline in value due to inflation.Inflation Risk?GoldStocksBondsAlternative InvestmentsReal Estate
  11. 11. Short Selling in the Commodities Marketplace11While there is a popular criticism that short selling impacts the price of a commodity (i.e.gasoline, orange juice, soy) in the real world, studies have shown that consumer pricesare not directly influenced by short sellers in the marketplace.An Interagency Task Force on Commodity Markets, which included representatives fromthe CFTC, produced a report in that concluded:“If a group of market participants has systematically driven prices, detailed dailyposition data should show that that group’s position changes preceded pricechanges. The Task Force’s preliminary analysis, based on the evidence available todate, suggests that changes in futures market participation by speculators havenot systematically preceded price changes.”*The Commodities Trade:Source: Interagency Task Force on Commodity Markets, Interim Report on Crude Oil. Washington D.C., July 2008.In the U.S., commodities markets are regulated by the CommodityFutures Trading Commission (CFTC).
  12. 12. Short Selling in the Commodities Marketplace12• Weather events• Political instability• Global economic performanceConsumer prices of commodities are most heavily driven by basic factors ofsupply and demand and variables such as:
  13. 13. Short Selling and Sovereign / Corporate DebtFor decades, governments have sold bonds to investors to help finance immediate infrastructure projectsand to meet their financial needs.Investors can take long and short investment views on individual countries‟ bond offerings and creditworthiness, based on their belief that the country will be able to repay the bond in full when it comes due.A short investment position in a government or corporate bond is taken by purchasing a credit default swap.This is the way an investor expresses their view that the country or company will not be able to pay the fullvalue of the bond at maturity, resulting in a lower redemption price.There are a number of factors that influence how investors view and evaluate individual countries‟ sovereigndebt offerings:• Political Volatility• Economic Volatility• Aging Population• Economic Growth/GDP13Short Selling and Sovereign / Corporate Debt:
  14. 14. Short Selling Restrictions14The Regulation of Short Selling:*Source The effects of short-selling public disclosure regimes on equity markets,“Oliver Wyman, pp. 7.Investors holding long and short positions are governed by the laws of the individualcountry – and marketplace – where they are trading.Throughout the years, countries have implemented a variety of additional restrictions governingthe practice of short selling.In the United States short selling is regulated by the Securities and Exchange Commission (SEC).Many of these restrictions have been temporary in nature, responding to a particular market eventor external factor – for example, U.S. regulators placed a ban on short selling of financial stocksduring the depths of the financial crisis in 2008. The goal of the ban was to prevent further declinein market value and reduce volatility, but studies have shown the ban did not have the intendedeffect.*The next slide provides more information on the impact of recent shortselling events.
  15. 15. Effects of Short Selling BansIn recent years, regulators have, specifically in the European Union, implemented temporary bans onshort selling activities following certain market fluctuations. Numerous studies analyzed the effects ofthese bans on financial markets, finding that bans:15*”"The effects of short-selling public disclosure regimes on equity markets,“ Oliver Wyman, pp. 7.=**”Why Banning Short-Selling Doesn‟t Do Any Good.” August 12, 2011. CNBC.com• Resulted in increasedvolatility• Made capital raising moredifficult for certain issuers• Reduced market efficiency• Decreased trading volumeand market liquidity• Increased bid-ask spreadsEffect of Short Selling Bans:Conclusion: Short selling bans did not stop steep price declines in the US and UK securitiesmarkets in 2008.
  16. 16. Short Selling RestrictionsCurrently there are a number of short selling restrictions in place in the E. U.:On November 1, 2012, the European Short Selling Regulation (SSR) went into effect. Underthe new regulation, European Union Member States will have authority to enact emergencybans during extreme periods of volatility.Part disclosure regime, part (naked)* sovereign shorting ban, the European regulations impacta wide variety of trades and there are signs that the markets are already adjusting.Generally, the rules ban the shorting of European sovereign debt other than as a hedge.The rules also require the disclosure of substantial short positions in listed Europeancompanies.*16*Naked short selling means an investor does not own the securities at the time of the sale and has not made arrangements to borrow them in time to make deliveryto the buyer.”*Source: Europe’s naked short selling ban leaves investors with skin in the game
  17. 17. ReferencesU.S. Regulatory Agencies:Securities and Exchange Commission (SEC)www.sec.govCommodity Futures Trading Commission (CFTC)http://www.cftc.gov/European Resources:European Securities and Market Authority (ESMA)www.esma.europa.eu/Financial Services Authority (UK)http://www.fsa.gov.uk/Additional Resources:International Organization of Securities Commissionshttp://www.iosco.org/17To read more about how federal regulators are handling issues related to short selling please see:

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