StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

The Cost of Short Selling - Essay Example

Cite this document
Summary
From the paper "The Cost of Short Selling" it is clear that short sellers actually ensure that the real value of a security is revealed as short selling actually reflects a genuine negative market sentiment that might be camouflaged by deliberate overpricing of security…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER93.3% of users find it useful
The Cost of Short Selling
Read Text Preview

Extract of sample "The Cost of Short Selling"

RUNNING HEAD: Costs of Short Selling Costs of Short Selling Contents Introduction 2 2. Short Selling – what does it signify? 2 3. Short selling as perceived by market commentators and regulators 5 4. Costs of Short Selling 6 5. Calculation of Short Selling Costs by averaging transaction costs of Mutual Funds – does it make any worthwhile difference? 9 6. Conclusion 11 7. References 14 1. Introduction Short selling has always been a vexatious issue with market regulators, governments and the general public. This issue has been analyzed in detail in the current assignment with impediments put up by relevant authorities to prevent or, at least, minimize short selling. It begins with a comprehensive description of activities related to short selling and commonly held perceptions about it by concerned groups. The costs related to short selling – both directly and immediately attributable to the activity and also those that result from taxation norms and procedures are discussed in depth to show that the chances of making a profit through short selling are as high as incurring a loss due to this activity. It all depends on how accurately an operator is able to predict the future market movements of stocks that are sold short. Mutual Funds hold largest number of stocks and are the most active operators in stock market. So, some analysts feel that if the additional costs related exclusively to short selling are added to the average cost of transactions undertaken by Mutual Funds, a correct value of the costs of short selling can be obtained. But the reasons why this approach would never give a true indication of short selling costs have been explained in a cogent manner. Finally, the assignment ends with a strong argument against branding short sellers as precursors of misfortune. 2. Short Selling – what does it signify? “Short selling” is a very common term in stock exchanges. In simple terms, if a seller sells stocks which are not owned by them, then they are selling it short. This is possible if the seller borrows those stocks from a broker for a limited period and would return those stocks later. In order to do this, the short seller must have an account with the broker. That account could be either cash account or margin account. A cash account requires all transactions to be settled in cash while in a margin account the broker comes forward with finance or securities, as the case may be, to fulfill temporary requirements of the investor. The investor has to; of course, provide collateral securities for all the shares that they borrow. One of the most pertinent costs of short selling is the interest foregone on the securities that are presented as collateral to the broker. A short seller undertakes these transactions because they have a hunch that the price of securities would go down in future. So when they would buy those stocks from open market for returning to the broker they would be able to do so at a lower price than at which they had sold the securities earlier. Thus the difference between the price at which the securities were sold and the price they were bought at a later date minus the interest foregone on the securities and brokerage fees paid can be termed as the cost of short selling. Though the risk involved in this entire process can never be quantified in money terms it must be mentioned that if the price of those securities rise instead of falling, the investor has to bear the loss of price differential and other costs of lost interest and brokerage fees (Yuille, 2010). The other inherent risk involved in the entire process is that the broker has the right to ask for the stocks they had loaned any time during the intervening period. If it happens, the investor has to return them immediately at the prevailing market price. Such a situation usually occurs if many investors decide to short sell a particular stock. The brokers then would be facing an excessive demand for that particular stock from their clients and would like to make some additional profit by charging higher brokerage fees. But they need to possess those stocks in the first place in order to loan them. So, they ask for a return of those stocks from the clients whom they had lent those stocks earlier. In such situations the earlier clients usually do not suffer financial loss but they might not make as much profit they would have wanted. If there is a splitting of the stock in the intervening period the investor has to return twice the number of stocks they had borrowed at theoretically half the price. This is a very distinct possibility as companies usually opt for a stock split if they perceive the current market price of the stock is too high to attract small investors. Short sellers on their part generally target those stocks that they perceive are selling at higher prices than they ought to and therefore would face a price correction any time. If by any chance the company opts for a stock split there is a big probability that the price of those stocks would no longer remain at half the previous price on account of buying pressure by new investors who had till then not been able to buy those stocks because of their high price. One of the most important conditions for a stock to be short sold is that it should be frequently traded else the scope of a future price reduction is greatly reduced. 3. Short selling as perceived by market commentators and regulators There is a widely held opinion by substantial sections of market commentators that as short sellers gain when the market declines, these operators try to influence the market in bearish manner to ensure that they gain at others’ expense. Some commentators had gone to the extent of stating that some short sellers had intentionally short sold airline stocks just before the mayhem of 9th September when twin towers of World Trade Center collapsed due to terrorist attacks as they had insider information that such a terrorist act would happen at any time (Thomas, 2006). Though there is absolutely no evidence in this regard, still the very fact that short seller gains when others lose has attached a stigma to the very term “short selling”. A comprehensive study by E. Chancellor of the so-called bearish influence exerted by short sellers has also concluded that there is absolutely no empirical evidence that short sellers are indeed able to depress the markets. Thus it would be unfair to blame these traders for any form of market collapse (Chancellor, 2001). However, there are certain restrictions in place for short sellers. Though such restrictions cannot be readily evaluated in money terms, they indeed add up to the cost of short selling and discourage short sellers from undertaking such transactions (Charoenrook & Daoak, 2005). While NASDAQ expressly prohibits its members from engaging in short selling, stocks traded in NYSE and AMEX (American Stock Exchange) can be sold short only at ‘plus-tick’ or in the least at ‘zero-tick’ prices. Top management of firms whose shares are liquid also oftentimes discourage short selling by splitting stocks or through adverse propaganda against short sellers. In the extreme, some firms have even taken recourse to legal suits against short sellers. As short selling occurs mainly in stocks that informed traders feel are overpriced and hence would face a price correction soon, some economists are of the opinion that high level of short interest automatically conveys the negative market impression about these stocks (Diamond & Verrechia, 1987). However, a contrarian view states that a high short interest in effect reflects a hidden demand for the stock which would in future be realized through actual purchases that would take place when such short sold stocks are to be bought from open market for returning to the lenders. 4. Costs of Short Selling In an instance of short sale, as discussed earlier, there has to be a lender who would supply securities that a short seller intends to sell. The borrower has to deposit collaterals worth 102% of the value of securities thus lent with the condition that the values of both collaterals and securities lent would be monitored on a daily basis. Any value differential would have to be covered by the borrower by depositing additional collaterals. A small portion of the collateral, often as small as 2%, has to be in the form of government bonds and the rest 98% has to be cash. If this transaction is between a broker and a short seller then an additional margin of 50% is required which, however, is not demanded if the transaction takes place between two brokers. In some UK and European markets, the collateral margin is often pegged at an even higher level of 105% (Mackinson Cowell, 2005). The lender gains from this entire process by getting usage benefit of the cash and of course the lending fee they collect from the borrower. Hence, if we assume the lending fee to be 25% and the prevailing market rate of interest as 5%, the short seller has to pay a total of 30% interest on the value of securities borrowed. This interest is calculated on a daily basis and is payable at the end of each month. Another element of cost of short selling is the effect of taxation of dividends that are declared during the period when such securities have been borrowed. Firms that lend stocks might not be able to avail of the preferential rates of taxation on dividends if such shares have been lent out on the dividend date. The increase in tax rates on dividends can be substantial, in some cases it might go up from the preferential rates of 15% to as high as 38%. Hence, lending firms are rather sensitive about this issue. Moreover, such dividends also do not qualify for deduction from total corporate income under the ‘Dividends Received Deduction’ clause. Thus lending entities suffer from both the ends unless of course they belong to the category that is exempted from dividend income such as pension funds (Thornock, 2010). Therefore, several lending entities resort to recalling loaned out securities prior to dividend dates. Such a recall affects the cost of short selling in a major way. Just as it happens in any other commodity market, if there is a reduction in supply, the supply curves shifts to its left and, assuming demand remains constant, this would result in a rise in equilibrium lending fees. This would make short selling an even more costly affair. Also, there is a stringent requirement of the Internal Revenue Code, section 1058 (b) (2) that borrowers should reimburse lenders the amount of dividend declared on the date when a security has been given on loan. Lenders also scrupulously follow this requirement mostly in order to avoid all possibilities of capital gains taxation that might occur if these securities are not shown as lent on the date of dividend declaration. However, it has been empirically confirmed that stock prices do not drop by the entire amount of dividend at a date after the declaration has been made. An example might make the situation clearer. Let us assume that the dividend amount per share is $100 and there has been only a $75 drop in market value of the stock after distribution of dividend. The borrower, however, has to return the full amount of $100 to the lender thus incurring a loss of $25 per share (Dechow, Hutton, Meulbroek, & Sloan, 2001). This partial drop in market value (i.e. not to the full extent of dividend amount) of a security on ex-date is generally the result of sensitivity to dividend and capital gains taxation. If a market did not have frictions as transaction costs, the equilibrium position would be; (Pcum – Pex) (1 – tcg) = Div(1 – tdiv) Therefore, Price Drop ratio = PDR = (Pcum – Pex) / Div = (1 – tdiv) / (1 – tcg)1 Pcum is the price of the stock on the day before it becomes ex-dividend, Pex is the ex-dividend price of the stock, Div is the amount of dividend, tcg is the capital gains tax rate and tdiv is the dividend tax rate (Elton & Gruber, 1970). Thus, dividend taxation and chances of capital gains tax significantly increase the cost of short selling especially near the cum-date. Short sellers generally avoid taking a short position till the ex-date arrives in order to not shoulder the dividend reimbursement cost. Lenders, on the other hand, also prefer to recall before dividend date to avoid excess tax burden. 5. Calculation of Short Selling Costs by averaging transaction costs of Mutual Funds – does it make any worthwhile difference? Mutual Funds are one of the largest dealers in securities and some of them segregate a portion of the securities available to them for the express purpose of short selling. Thus, there has been an attempt to calculate short selling costs by finding the average transaction costs of such mutual funds and adding on the extra charges and costs such as broker fees that are associated explicitly with short selling operation. However, one must remember that contrary to popular perceptions, there are many legal and institutional hurdles that prevent Mutual Funds from actively participating in short selling activities. More than 70% of Mutual Funds are explicitly prohibited by their charters to engage in short selling (Almazan, Brown, Carlson, & Chapman, 2004) and many countries, including Finland, Spain and New Zealand, either totally ban or have put in place tax structures that make it commercially unfeasible for Mutual Funds to engage in short selling (Charoenrook & Daoak, 2005). Cultural norms in certain countries also look down upon short selling and mutual funds rarely ever engage in that activity for fear of attracting public opprobrium. Thus, most Mutual Funds usually avoid short selling as a matter of practice. But even if we assume for argument’s sake that Mutual Funds regularly and vigorously take part in short selling activities, it still becomes rather difficult to isolate the costs related explicitly to such activities. The main reason is that Mutual Funds believe on the principle that through repeated buying and selling investors’ return can be maximized. Thus, almost all mutual funds believe in turnover, which is buying selling the stocks at their disposal repeatedly throughout the year. The higher the turnover, the greater is the perceived return on investors. Keeping this philosophy in focus, Mutual Funds concentrate exclusively on turnover so much so that the average turnover for Mutual Funds is 85% meaning that almost all the stocks at their disposal gets either bought or sold during the course of one year. Some Mutual Funds even have turnover ratios more than 100% implying that their average stock holding period is less than one year (Barker, 2010). When these Funds are so engaged in ensuring turnover of the stocks they have at their disposal, they would hardly have any time left to concentrate on short selling stocks that they do not have at their disposal. Even if they decide to do short selling it would be too much of paperwork for them to maintain records of such transaction over and above the myriad transactions that they have to engage in order to maintain their high turnover rate. The other issue in this regard is that Mutual Funds have to maintain reasonably high levels of cash in order to be able to buy at will. Mutual Funds, on an average, maintain 8% of their funds (Barker, 2010) in the form of liquid cash and the loss of potential return on this cash reserve is spread over actively traded securities thereby lowering their net return. There is of course another reason for holding this substantial amount of cash and that is in case of a sudden panic among investors, the Mutual Fund would be able to satisfy investor demands of reimbursement of funds without selling securities at a time when the market is at its sluggish worst. Therefore the actual costs incurred by Mutual Funds include repeated brokerage fees due to high rates of turnover and the cost of idle cash maintained by them as a matter of policy. So, if one considers the average cost of transaction by a Mutual Fund and adds to it the costs explicitly associated with short selling, it would never reflect the correct picture. 6. Conclusion Costs of short selling are rather high as is obvious from what has been discussed above. Over and above the lost interest on the cash deposit which happens to be at least 98% of the total value of collaterals, a short seller must also be prepared to keep idle cash at their disposal to deposit it in the event of any sudden drop in market value of the collaterals. If one adds the usually high lending fee to the cost of lost interest on cash deposit and also the idle cash then the effective cost of short selling becomes rather high. On top of these costs, the short seller also has to pay interest on the value of securities borrowed. This interest is calculated on a daily basis. So, if by any chance the market value of securities rise even once in the intervening period, that is, during the period for which the securities had remained borrowed, the short seller has to pay additional interest. This is in spite of the fact that the final value of the securities short sold might actually be lower than what they were on the day they were borrowed. Therefore, a short seller indeed takes a lot of risk while undertaking such a venture. The other cost factor in short selling arises from tax imposed on dividend on the borrowed shares that might be declared during the period they had remained borrowed. Internal Revenue Code, section 1058 (b) (2) strictly stipulate that borrowers reimburse lenders the amount of dividend earned by shares that they have borrowed. As has been discussed in detail in the main body of the assignment, the security prices do not drop by the full amount of the dividend declared. So, the borrowers suffer an extra cost to the extent of the difference between the amount of dividend declared and the drop in security price. This cost, however, is incurred only in case dividend is declared during the period the securities had remained borrowed. This could perhaps be the reason as to why short sellers generally do not prefer to take ‘short positions’ around the dates when dividends are declared. Hence it seems rather unjust to blame short sellers for any downward movement in stock indices. In fact some academicians have asserted that short sellers actually ensure that the real value of a security is revealed as short selling actually reflects genuine negative market sentiment that might be camouflaged by deliberate overpricing of a security (Korn, 1999). Another economist squarely blamed the unseemly haste exhibited by the SEC in the aftermath of global meltdown in 2008 when it severely restricted short selling activities as being one of the chief reasons for such late recovery of markets and the economy as a whole (Reed, 2009). 7. References Almazan, A., Brown, K., Carlson, M., & Chapman, D. (2004). Why constrain your mutual fund manager? Journal of Financial Economics 73 , 289-321. Barker, B. (2010). Mutual Funds: Costs: Turnover and Cash Reserves. Retrieved January 3, 2011, from The Motley Fool: http://www.fool.com/school/mutualfunds/costs/turnover.htm Chancellor, E. (2001). A Short History of the Bear. London: David Tice & Co. Charoenrook, A., & Daoak, H. (2005). A Study of Market-Wide Short Selling Restrictions. Vanderbilt University Working Paper. Dechow, P., Hutton, A., Meulbroek, L., & Sloan, R. (2001). Short interest, fundamental analysis and market efficiency. Journal of Financial Economics 61 , 77-106. Diamond, D., & Verrechia, R. (1987). Constraints on Short Selling and Asset Price Adjustments to Private Information. Journal of Financial Economics, Vol. 18 , 277-311. Elton, E., & Gruber, M. (1970). Marginal stockholder tax rates and the clientele effect. Review of Economics and Statistics 52 , 68-74. Korn, D. J. (1999, August). Short-Selling Strategies. Black Enterprise , pp. 50-53. Mackinson Cowell. (2005). Stock Lending – A Perspective. London, New York: Mackinson Cowell. Reed, A. (2009). Dont Blame the Short Sellers: Sometimes the best of intentions have negative consequences. Retrieved January 3, 2011, from UNC Kenan-Flagler: http://www.kenan-flagler.unc.edu/roi/short-sellers.cfm Thomas, S. H. (2006, March). Short Selling: Discussion of Short Sales Constraints and Momentum in Stock Returns. Retrieved December 30, 2010, from Centre for Risk Research Working Papers: School of Management: University of Southampton: http://eprints.soton.ac.uk/37474/1/CRR-06-01.pdf Thornock, J. R. (2010). The Effects of Dividend Taxation on Short Selling. Chapel Hill: University of North Carolina. Yuille, B. (2010). Short Selling: What Is Short Selling? Retrieved December 30, 2010, from Investopedia: http://www.investopedia.com/university/shortselling/shortselling1.asp Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(“The cost of shortselling (finance) Essay Example | Topics and Well Written Essays - 3000 words”, n.d.)
The cost of shortselling (finance) Essay Example | Topics and Well Written Essays - 3000 words. Retrieved from https://studentshare.org/miscellaneous/1574811-the-cost-of-shortselling-finance
(The Cost of Shortselling (finance) Essay Example | Topics and Well Written Essays - 3000 Words)
The Cost of Shortselling (finance) Essay Example | Topics and Well Written Essays - 3000 Words. https://studentshare.org/miscellaneous/1574811-the-cost-of-shortselling-finance.
“The Cost of Shortselling (finance) Essay Example | Topics and Well Written Essays - 3000 Words”, n.d. https://studentshare.org/miscellaneous/1574811-the-cost-of-shortselling-finance.
  • Cited: 0 times

CHECK THESE SAMPLES OF The Cost of Short Selling

The Sales Ethics an Oxymoron

Many people are of the view that selling are mutually exclusive.... elling ethically, like all High Probability selling principles, has been proven to statistically boost the probability of closing sales.... Many salespeople report that truthfulness also reduces the stress and anxiety associated with the selling process.... Radically Honest selling is a Win-Win situation for both Buyers and Sellers.... Salespeople enjoy their work more - and enjoy greater financial rewards (The Truth About Truth in selling: Sales Ethics is NOT an Oxymoron, 2004)....
6 Pages (1500 words) Essay

Different Cost Concepts

In short, Period costs are reported on the income statement separated from the cost of goods sold section.... By estimating the manufacturing cost, the management is able to value the units produced in a year, cost of goods sold and inventory, which ultimately, is reported in the income statement and balance sheet of the company.... Moreover, if the product is sold it is recorded as cost of Goods Sold in the books of accounts and then COGS is matched against the revenue (matching principle) generated by selling the product....
5 Pages (1250 words) Essay

Short Run vs. Long Run

Another cost driver incorporation is the cost of materials.... The two projects not selected are the opportunity cost of the selected project.... A person that decides to use his time studying for college has the opportunity cost of the money he could make working in the private industry.... A person that decides to use his time studying for college has the opportunity cost of the money he could make working in the private industry....
2 Pages (500 words) Essay

Product Development and selling

This is a commodity which is popular with very many people including Lecturer Product Development and selling If I were to venture in manufacturing business, I would ensure that I produce a commodity which is relevant to my target audience and can be of great significance to them.... hus, for my business, I would have to incur the following expenses:Fixed Costs: furniture, equipments, rent and prices of the materialsVariable Costs: Electricity, salaries, wages, sales promotions and taxesBreak Even AnalysisBreakeven = Total Fixed Cost / (selling Price - Variable Cost)Total Fixed Costs =$10,000Price =$11Variable Costs =$1 Break Even= 10,000/ ($11-$1)Break Even= $1,000When this is done, the business will be able to make some profit....
2 Pages (500 words) Essay

Online Business of Vibe T-shirt Would Be Remunerative and Profitable

The online marketing and selling of T-shirts of Vibe brand are considered to be highly competitive as e-commerce has emerged to be a recent trend with various companies investing in an online commodity business.... The pricing has also been fixed taking into consideration the expenses incurred for procuring the raw materials, wages, general selling and administrative costs.... The cash budget has provided an indication of the amount of cash deficit or surplus that would occur from the online selling of Vibe T-shirt....
4 Pages (1000 words) Essay

Skills Available For Acquisition and Career Building Strategies in Directing a Film

This study gives attention to potential skills available for acquisition and career building strategies in building a good career in directing a film.... Directing a film is a very important aspect in filming because of it the action that eventually makes the video realized by people.... ... ... ...
9 Pages (2250 words) Case Study

Cyclermate and Short-Term Measures

This resulted from the reduction of selling price for direct and shop sales despite an increase in the material unit costs.... All the marginal costs of direct raw materials, indirect materials, administration, selling and distribution as well as wages and salaries have been on the rise.... The selling and distribution costs can only be minimized by increasing the number of budgeted shop sales to be a par to direct sales at £780 per unit....
12 Pages (3000 words) Assignment

Sport-Traxs Marketing Strategy

The author of the paper 'Sport-Trax's Marketing Strategy' states that it appears that Sport-Trax does not have a structured marketing function.... This assumption arises from the incident in which a salesperson is able to discuss such important operational matters with the Head of the company, as to who should serve a prime account....
15 Pages (3750 words) Essay
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us