Short selling stock

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Selling stocks you do not own, with the intention of repurchasing them at a lower price later, is known as selling stock short. The act of buying back the stocks that were sold short is called "covering the short" or "covering the position". A short position can be covered at any time before the stocks are due to be returned.[1][note 1]

When securities that have been lent out pay a cash dividend, the borrower of the securities is in general contractually required to pass the distribution back to the lender of the securities. This payment “pass-through” is known as a manufactured dividend. [2]

An equity lending market exists to match these short sellers with owners of the stock willing to lend their shares for a fee.[3]

Refer to the figure below. An investor who wants to sell a stock short first finds a party willing to lend the shares. The shares are then sold short and delivered to the borrower, with the lender receiving 102% of the loan (US stocks) in collateral. When the shares are returned to the lender, the collateral is returned to the borrower.[3]

While a stock is on loan, the lender invests the collateral and receives interest on this investment. Generally, the lender returns part of the interest to the borrower in the form of a negotiated rebate rate. Therefore, rather than fees, the primary cost to the borrower is the difference between the current market interest rate and the rebate rate the lender pays the borrower on the collateral.[3]

Short Sale Loan Structure
Short Sale Loan Structure.png

The stock owner faces three types of risk when lending stock:[3]

  • Investment risk: Choices that the beneficial owner or their agent make in investing collateral
  • Counterparty risk: The borrower fails to provide additional collateral or fails to return the security
  • Operational risk: Responsibilities of the lender or borrower are not met

The stock borrower faces two types of risk: the risk of a loan recall and the risk of a decrease in rebate rates.[3]

See also

Notes

References

  1. Wikipedia:Short (finance)
  2. securities lending glossary I-M, Securities Lending Times | Glossary
  3. 3.0 3.1 3.2 3.3 3.4 Fabozzi, Frank J., "Handbook of Finance: Financial Markets and Instruments," John Wiley & Sons, 2008, Chapter 70, Accessed 09-Mar-13 at Safari Books Online - Premium. ISBN 978-0-470-07814-3

External links