1. 1 Financing Techniques for Short Sellers Stuart McCrary

2. 2 Reading Questions 1. What costs are borne by a short seller that cannot borrow the security and fails to make delivery? 2. You borrow a security, but the lender fails to deliver and you also fail. What is your cost of failing? 3. Under what circumstances would the rebate rate or reverse repo rate be negative? 4. What is the size of the substitute interest or dividend payment that the short seller must pay on the payment date? 5. You expect a security to trade 150 bp special for two months. What impact might that have on the price of the security? 6. You finance both long and short positions with a financing counterparty. The market is up 10% on average. What is needed to properly maintain the financing positions? 7. Why might it be advantageous to finance both long and short positions with a single counterparty? 8. What conditions lead to positive carry on short positions? 9. What is the cost of carrying a pairs trade? 10. What are the pros and cons of term financing?

3. 3 Cost of Fail The short seller does not receive the selling price until the securities are delivered. The cost equals the settlement value of the trade (including accrued interest in the case of bonds) times the daily short term rate times the number of days failed.

4. 4 Offsetting Cost of Fail There is very little net cost for in and out fails. When the lender fails to make delivery, you dont need to post cash collateral, so you get an interest- free loan from the lending counterparty. However, you bear an approximately equal cost if you also cannot make delivery on the sale.

5. 5 Negative Financing Rates The harder a security is to borrow (because of scarce availability or high demand) the lower the rebate rate or reverse repo rate will be. However, financing rates will not generally decline below zero unless there are restrictions on failing to deliver or provisions for the failing party to pay additional compensation to the receiving party.

6. 6 Making Substitute Income Payments The short seller must make a payment equal to the coupon payment or dividend on the payment date. Usually, the short seller makes the payment by bank wire.

7. Price Adjustments to Special Rates A short seller must absorb the cost and a holder could lend the issue to earn extra income. Therefore, the equilibrium price of the security will rise by the amount of the special financing. 7

8. 8 Marking to Market Financing Positions Parties should set new values for financed long and short positions. Trader must put up extra funds to collateralize shorts with higher prices but long positions can collateralize higher borrowing. One party will send the other a single collateral adjustment payment.

9. 9 Matched Book as Risk Control Long positions and short positions create offsetting mark to market differences. Matching the sensitivity of long and short positions reduces the exposure to extreme price movements, mitigating credit exposure to the financing counterparty.

10. The Carry Trade – Short Positions Long positions have positive carry if the coupon yield is higher than the financing rate. This is typical of many bonds. Short positions have positive carry if the coupon yield is lower than the financing rate. This is typical of many stocks. 10

11. Cost of Carrying Pairs Trade The trade will earn the dividend rate on the long position less the dividend rate on the short. The collateral on the short will earn a below-market rate. The money borrowed to finance the long will probably be higher. 11

12. Term Financing The overnight market trades much more actively than the term markets. Term trades can lock in costs to reduce financing risks. Term trades are harder to unwind when positions are liquidated. 12

13. 13 Conclusion This survey provided insight into: The day to day operation of the financing markets Managing counterparty risk Impact of financing costs on profitability