1. Additional Topics Additional items to address: Holding Period Return Short Selling with Margin Requirements

2. Short Selling and Margin In the previous class we talked about how it was possible to perform a short sale on a financial instrument by borrowing it from the inventory of a dealer and selling it to a third party The hope is that the instrument declines in price and you can re-supply it to the dealer buy purchasing in the open market at the lower price and make a profit Clearly, the dealer is taking some sort of credit risk when he allows you to borrow the instrument, so he sets up some requirements to protect his interest

3. Short Selling and Margin Initial Margin = Amount required to initiate the trade = Amount generated from sale of borrowed assets PLUS an additional amount to cover the risk that the price of the stock may increase The additional amount is usually a function of the initial value of the trade So if you short sell n shares of a stock valued at time zero at S 0, and the initial margin requirement is u, then the initial value of the sale is n S 0, and the additional initial margin = u n S 0

4. Short Selling and Margin To minimize the credit risk, the dealer will always require that the “investor’s equity position” be at least a fraction v of the market value of the assets (v < u ) This is called the maintenance margin requirement “Investor’s Equity Position” - recall that on a balance sheet, a person’s “equity” or “surplus” is the difference between the assets they own and the liabilities they have promised to fulfill

5. Short Selling and Margin Note that Investor’s Equity = Investor’s Asset – Investor’s Liability = (Gain from short sale + additional initial margin) - Current Market Price of Stock = n S 0 + u n S 0 - n S 1 So dealer requires that n S 0 + u n S 0 - n S 1 > v n S 1

6. Short Selling and Margin Example: Sell Short 100 shares of stock at current price of $65, initial margin requirement = 50%, maintenance margin requirement of 30% So investor sells the 100 shares and receives $6500, plus must also keep an additional $3250 on deposit. Total initial asset = $9750 Maintenance Margin = 30% * 100 * Current Market Price Stock price goes to $70: Investor’s Equity = n S 0 + u n S 0 - n S 1 = $6500 + $3250 - $7000 = $2750 Maintenance Margin = 30% * 100 * 70 = $2100 Since Equity > Maintenance Margin, then no adjustments needed

7. Short Selling and Margin Stock price goes to $80: Investor’s Equity = n S 0 + u n S 0 - n S 1 = $6500 + $3250 - $8000 = $1750 Maintenance Margin = 30% * 100 * 80 = $2400 Since Equity < Maintenance Margin, so an adjustment needed via a margin call Dealer may require that the full initial additional margin of $3250 is re-established

8. Short Selling and Margin At what exact price would a margin call be initiated? Where n S 0 + u n S 0 - n S 1 = v n S 1 Solving for S 1 : S 1 = (n S 0 + u n S 0 ) / (n + v n) In our example: S 1 = ($6500 + $3250 ) / (100 +.3(100)) = $9750 / 130 = $75