AdditionalMaterials - Short Sales An Overview AD.6 Short...

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Short Sales An Overview AD.6 Short Sales An Overview This handout is a reproduction of section 2.4.2 (pages 25-30) of Sharpe, William F., and Gordon J. Alexander, 1990, Investments , Prentice-Hall, New Jer- sey. Introduction An old adage from Wall Street is to “buy low, sell high.” Most investors hope to do just that by buying securities ±rst and selling them later. 6 However, with a short sale this process is reversed. The investor sells a security ±rst and buys it back later. In this case the old adage about investor aspirations might be reworded as “sell high, buy low.” Short sales are accomplished by borrowing stock certi±cates for use in the initial trade and then repaying the loan with certi±cates obtained in a later trade. Note that the loan here involves certi±cates, not dollars and cents (although it is true that the certi±cates at any point in time have a certain monetary value). This means the borrower must repay the lender by returning certi±cates, not dollars and cents (although it is true than an equivalent monetary value, determined on the date the loan is repaid, can be remitted instead). It also means that there are no interest payments to be made by the borrower. Rules Governing Short Sales Any order for a short sale must be identi±ed as such. The Securities and Exchange Commission has ruled that short sales may not be made when the market price for the security is falling, on the assumption that the short seller would exacerbate the situation, cause a panic, and pro±t therefrom— an assumption inappropriate for an efficient market with astute, alert traders. The precise rule is that a short sales must be made on an up-tick (for a price higher than that of the previous trade) or on a zero-plus tick (for a price equal to that of the previous trade but higher than that of the last trade at a di²erent price). Within ±ve business days after a short sale has been made, the short-seller’s broker must borrow and deliver the appropriate securities to the purchaser. The borrowed securities may come from the inventory of securities owned by the brokerage ±rm itself or the inventory of another brokerage ±rm. However, they are more likely to come from the inventory of securities held in street name by the brokerage ±rm for investors that have margin accounts with the ±rm. The life of the loan is inde±nite, meaning there is no time limit on it. 7 If the lender wants to sell the securities, then the short seller will not have to repay the loan if the brokerage ±rm can borrow shares elsewhere, thereby transferring the loan from one source to another. However, if the brokerage ±rm cannot ±nd a place to borrow the shares, then the short seller will have to repay the loan immediately.
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AdditionalMaterials - Short Sales An Overview AD.6 Short...

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