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Short selling


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Short selling

  1. 1. Concentrated Ownership (percentage of shares held by the major shareholder)• Generally accepted assumption is that owners desire to maximize profits or wealth. At the same time managers have other interests (high compensation, low effort levels, expense preference, empire buildings etc). Therefore, owners need some sort of control over managers to achieve their objective. Ownership concentration is one of the pre-requisites to influence on managers activities.• However, using 102 listed companies, Pathirawasam (2011) finds that ownership concentration does not have a significant positive relationship with company performance in Sri lanka.
  2. 2. Concentrated Ownership (percentage of shares held by the major shareholder)• In developed markets average ownership concentration is at a lower level.• In Sri Lanka ownership concentration is very high.• When the ownership is concentrated, price manipulation could be possible.• In a ownership concentrated firm, share supply curve may be inelastic.• However, the share demand curve is elastic. As a result of that share price manipulation may be possible.
  3. 3. Share Supply CurveP Q
  4. 4. Share Demand CurveP D Q
  5. 5. Equilibrium PriceP Sp2p1 D2 D1 Q1Q2 Q
  6. 6. • If the share supply is also elastic, market will establish a fair price.• As the number of shares issued is a constant, allowing short selling would be a one possibility to have elastic supply curve.
  7. 7. Merging Trading• Margin account provides overdraft facilities to buy securities.• With a merging account the investor must pay part of the purchasing cost in cash and can borrow the rest from the brokerage firm.• Securities purchased under margin should be deposited with the brokerage firm.
  8. 8. Ex. Ms. Smith purchased on margin 100 shares of XYZ Ltd.Share certificate is retained with the brokering firm and benefitsdue to purchase of share are transferred through the brokeringfirm. Financial reports Financial reports Dividend Dividend Broker Mr. X Voting right Voting right
  9. 9. Initial Margin Requirement• The minimum percentage of the purchase price that come from the investor’s own fund.• Ex. Ms. Smith purchases on margin 100 stocks of XYZ lid. For 50 Rs per share. If the initial margin is 60%. The investor must pay the broker 3000 Rs (50*100*0.6). The remainder (2000) is a loan from the broker.
  10. 10. Marked to the Market• Compute actual margin regularly to maintain the necessary margin requirement (maintenance margin is determine by the exchange). Market Value Loan Actual m arg in Market Value• If XYZ stock fell to Rs 25 per share then the actual margin would drop to 20% [2500-2000)/2500].• If the actual margin is below the maintenance margin, broker will issue a margin call.
  11. 11. Short Sales• In SS the investor sells a security first and buys it back later.• SS is accomplished by borrowing stock certificates and repay the loan with certificate (not by money).• With in three business days, the short seller’s broker must borrow and deliver the appropriate securities to the buyer.
  12. 12. The Borrowed Securities May Come From• The inventory of securities owned by the brokerage firm.• The holdings of an institutional investor that is willing to sell securities.• The inventory of securities held by brokerage firm for investors who have margin accounts with the broker firm.
  13. 13. Ex: Before Short SaleMr. Lane owns 100 shares of XYZ company , which are being held for him byBrock, Inc. Forwards everything Dividends, annual XYZ Brock Inc Mr. Lane reports, voting rights
  14. 14. The Short Sale• Ms. Smith paces an order with her broker at Brock to short sell shares of XYZ (Mr. Lane believes that the price of XYZ stock is going to rise in the near future, whereas Ms. Smith believes that it is going to fall). Here Brock takes the 100 shares of XYZ that it is holding on behalf of Mr. Lane and sells them for Ms. Smith to Mr. Jones.
  15. 15. Ex: The Short Sale Mr. Jones Pays Purchase Receives stock Price certificate Notified that Mr. Jones Allows stockXYZ Brock Inc Mr. Lane now owns stock To be lent Provides initial margin Mrs. Smith
  16. 16. After The Short Sale• If XYZ announce dividends it will go to Mr. Jones and not to Brock on behalf of Mr. Lane. However Mr. Lane is also expecting the dividend. Therefore the Brock will charge that amount form Mr. Smith and transfer to Mr. Smith. Normally annual reports are received by Brokering firms free of charge. Therefore Brock will mail a copy to Mr. Lane.
  17. 17. Ex: After the Short Sale Mr. Jones Annual reports AnnualXYZ Brock Inc Mr. Lane Reports, Divide nds Provides cash to make up for dividends Mrs. Smith
  18. 18. How to Avoid the Risk that the Borrower will not Repay the Loan1. cash proceeds from the short sale are not given to the short seller. They are held with Broker firm until the short seller repays the loan.2. Short seller must also give the broker initial margin applied to the amount of the short sale.3. Establish a maintenance margin that protects the brokerage firm from losing money in a situation where share price increase after short sale. Actual margin= (short sale proceeds + initial margin)-loan loan
  19. 19. • Ex. 100 shares of XYZ were sold at a price of Rs 100 per share. In this case proceeds of Rs. 10000 from the short sale are held in Ms. Smith’s account, but she is prohibited from withdrawing them until the loan is repaid. If the initial margin requirement was 60%, she must give her broker 6,000 (.6*10000).• If XYZ stock rises to Rs. 130 per share, the initial margin in Ms. Smith’s account will be 23% = *(100*100+6,000)- (130*100)]/(130*100)= 3000/13000. If the maintenance margin requirement is 30%. The account is under margined causing Ms. Smith to receive a margin call.
  20. 20. Rate of Return• Ms. Smith short sold XYZ stock at a price of Rs 100 per share. If she later repays the short loan when the stock is selling for Rs75 per share and just after XYZ has paid a Rs1 per share cash dividend. Then her rate of return is, (100-75-1)/(0.6*100)=24/60 =40%Return of a person who had purchase the stock on cash basis (75+1-100)/100 = -24%