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10,000
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Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition




86 Part ONE Elements of Investments
Table 3.7 summarizes the possible results of these hypothetical transactions. If there is no
change in IBM™s stock price, the investor loses 9%, the cost of the loan.
4. Suppose that in the previous example, the investor borrows only $5,000 at the

>
same interest rate of 9% per year. What will the rate of return be if the price of IBM
Concept
goes up by 30%? If it goes down by 30%? If it remains unchanged?
CHECK

3.7 SHORT SALES
Normally, an investor would first buy a stock and later sell it. With a short sale, the order is re-
versed. First, you sell and then you buy the shares. In both cases, you begin and end with no
shares.
A short sale allows investors to profit from a decline in a security™s price. An investor bor-
rows a share of stock from a broker and sells it. Later, the short-seller must purchase a share
short sale
of the same stock in the market in order to replace the share that was borrowed. This is called
The sale of shares not
covering the short position. Table 3.8 compares stock purchases to short sales.
owned by the investor
The short-seller anticipates the stock price will fall, so that the share can be purchased later
but borrowed through
a broker and later at a lower price than it initially sold for; if so, the short-seller will reap a profit. Short-sellers
purchased to replace must not only replace the shares but also pay the lender of the security any dividends paid dur-
the loan.
ing the short sale.
In practice, the shares loaned out for a short sale are typically provided by the short-seller™s
brokerage firm, which holds a wide variety of securities of its other investors in street name.


Change in End-of-Year Repayment of Investor™s
TA B L E 3.7 Stock Price Value of Shares Principal and Interest* Rate of Return
Illustration of buying
30% increase $26,000 $10,900 51%
stock on
margin No change 20,000 10,900 9
30% decrease 14,000 10,900 69

*Assuming the investor buys $20,000 worth of stock by borrowing $10,000 as an interest rate of 9% per year.




Purchase of Stock
TA B L E 3.8
Cash Flow*
Time Action
Cash flows from
purchasing versus
0 Buy share Initial price
short-selling shares
1 Receive dividend, sell share Ending price Dividend
of stock
Profit (Ending price Dividend) Initial price


Short Sale of Stock

Time Action Cash Flow

0 Borrow share: sell it Initial price
1 Repay dividend and buy (Ending price Dividend)
share to replace the share
originally borrowed
Profit Initial price (Ending price Dividend)

*Note: A negative cash flow implies a cash outflow.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition




87
3 How Securities Are Traded


The owner of the shares need not know that the shares have been lent to the short-seller. If the
owner wishes to sell the shares, the brokerage firm will simply borrow shares from another in-
vestor. Therefore, the short sale may have an indefinite term. However, if the brokerage firm
cannot locate new shares to replace the ones sold, the short-seller will need to repay the loan
immediately by purchasing shares in the market and turning them over to the brokerage house
to close out the loan.
Exchange rules permit short sales only when the last recorded change in the stock price is
positive. This rule apparently is meant to prevent waves of speculation against the stock. In
essence, the votes of “no confidence” in the stock that short sales represent may be entered
only after a price increase.
Finally, exchange rules require that proceeds from a short sale must be kept on account
with the broker. The short-seller cannot invest these funds to generate income, although large
or institutional investors typically will receive some income from the proceeds of a short sale
being held with the broker. Short-sellers also are required to post margin (cash or collateral)
with the broker to cover losses should the stock price rise during the short sale.
To illustrate the mechanics of short-selling, suppose you are bearish (pessimistic) on Dot
Bomb stock, and its market price is $100 per share. You tell your broker to sell short 1,000
shares. The broker borrows 1,000 shares either from another customer™s account or from an-
other broker.
The $100,000 cash proceeds from the short sale are credited to your account. Suppose the
broker has a 50% margin requirement on short sales. This means you must have other cash or
securities in your account worth at least $50,000 that can serve as margin on the short sale.
Let™s say that you have $50,000 in Treasury bills. Your account with the broker after the short
sale will then be:

Assets Liabilities and Owners™ Equity
Cash $100,000 Short position in Dot Bomb stock
(1,000 shares owed) $100,000
T-bills 50,000 Equity 50,000

Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current
value of the shares you have borrowed and eventually must return, $100,000:
Equity $50,000
Percentage margin .50
Value of stock owed $100,000
Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your po-
sition at a profit. To cover the short sale, you buy 1,000 shares to replace the ones you bor-
rowed. Because the shares now sell for $70, the purchase costs only $70,000.5 Because your
account was credited for $100,000 when the shares were borrowed and sold, your profit is
$30,000: The profit equals the decline in the share price times the number of shares sold short.
On the other hand, if the price of Dot Bomb goes up unexpectedly while you are short, you
may get a margin call from your broker.
Suppose the broker has a maintenance margin of 30% on short sales. This means the equity
in your account must be at least 30% of the value of your short position at all times. How
much can the price of Dot Bomb stock rise before you get a margin call?

5
Notice that when buying on margin, you borrow a given amount of dollars from your broker, so the amount of the
loan is independent of the share price. In contrast, when short-selling you borrow a given number of shares, which
must be returned. Therefore, when the price of the shares changes, the value of the loan also changes.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition




EXCE L Applications www.mhhe.com/bkm


> Short Sale


This Excel spreadsheet model was built using the text example for Dot Bomb. The model allows
you to analyze the effects of returns, margin calls, and different levels of initial and maintenance
margins. The model also includes a sensitivity analysis for ending stock price and return on in-
vestment. The original price for the text example is highlighted for your reference.
You can learn more about this spreadsheet model using the interactive version available on our
website at www.mhhe.com/bkm.

A B C D E F
1 Chapter 3
2 Short Sale
3 Dot Bomb Short Sale
4 Ending Return on
5 Initial Investment 50000.00 St Price Investment
6 Beginning Share Price 100.00 60.00%
7 Number of Shares Sold Short 1000.00 40 120.00%
8 Ending Share Price 70.00 50 100.00%
9 Dividends Per Share 0.00 60 80.00%
10 Initial Margin Percentage 50.00% 70 60.00%
11 Maintenance Margin Percentage 30.00% 80 40.00%
12 90 20.00%
13 Return on Short Sale 100 0.00%
14 Gain or Loss on Price 30000.00 110 -20.00%
15 Dividends Paid 0.00 120 -40.00%
16 Net Income 30000.00 130 -60.00%
17 Return on Investment 60.00%
18
19
20 Margin Positions
21 Margin Based on Ending Price 114.29%
22
23 Price for Margin Call 115.38




Let P be the price of Dot Bomb stock. Then the value of the shares you must pay back is
1,000P, and the equity in your account is $150,000 1,000P. Your short position margin ratio
is equity/value of stock (150,000 1,000P)/1,000P. The critical value of P is thus
Equity 150,000 1,000P
.3
Value of shares owed 1,000P
which implies that P $115.38 per share. If Dot Bomb stock should rise above $115.38 per
share, you will get a margin call, and you will either have to put up additional cash or cover
your short position by buying shares to replace the ones borrowed.

5. a. Construct the balance sheet if Dot Bomb goes up to $110.

>
b. If the short position maintenance margin in the Dot Bomb example is 40%, how
Concept
far can the stock price rise before the investor gets a margin call?
CHECK
You can see now why stop-buy orders often accompany short sales. Imagine that you short
sell Dot Bomb when it is selling at $100 per share. If the share price falls, you will profit from
the short sale. On the other hand, if the share price rises, let™s say to $130, you will lose $30
per share. But suppose that when you initiate the short sale, you also enter a stop-buy order at
$120. The stop-buy will be executed if the share price surpasses $120, thereby limiting your
losses to $20 per share. (If the stock price drops, the stop-buy will never be executed.) The
stop-buy order thus provides protection to the short-seller if the share price moves up.
88
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition




89
3 How Securities Are Traded


3.8 REGUL ATION OF SECURITIES MARKETS
Trading in securities markets in the United States is regulated by a myriad of laws. The major
governing legislation includes the Securities Act of 1933 and the Securities Exchange Act of
1934. The 1933 Act requires full disclosure of relevant information relating to the issue of new
securities. This is the act that requires registration of new securities and issuance of a prospec-
tus that details the financial prospects of the firm. SEC approval of a prospectus or financial
report is not an endorsement of the security as a good investment. The SEC cares only that the
relevant facts are disclosed; investors must make their own evaluation of the security™s value.
The 1934 Act established the Securities and Exchange Commission to administer the pro-
visions of the 1933 Act. It also extended the disclosure principle of the 1933 Act by requiring
periodic disclosure of relevant financial information by firms with already-issued securities on
secondary exchanges. Of course, disclosure is valuable only if the information disclosed faith-
fully represents the condition of the firm; in the wake of the corporate reporting scandals of
2001 and 2002, confidence in such reports justifiably waned. Under legislation passed in
2002, CEOs and chief financial officers of public firms will be required to swear to the accu-
racy and completeness of the major financial statements filed by their firms.
The 1934 Act also empowers the SEC to register and regulate securities exchanges, OTC
trading, brokers, and dealers. While the SEC is the administrative agency responsible for
broad oversight of the securities markets, it shares responsibility with other regulatory agen-
cies. The Commodity Futures Trading Commission (CFTC) regulates trading in futures mar-
kets, while the Federal Reserve has broad responsibility for the health of the U.S. financial
system. In this role, the Fed sets margin requirements on stocks and stock options and regu-
lates bank lending to securities markets participants.
The Securities Investor Protection Act of 1970 established the Securities Investor Protection
Corporation (SIPC) to protect investors from losses if their brokerage firms fail. Just as the Fed-
eral Deposit Insurance Corporation provides depositors with federal protection against bank
failure, the SIPC ensures that investors will receive securities held for their account in street
name by a failed brokerage firm up to a limit of $500,000 per customer. The SIPC is financed
by levying an “insurance premium” on its participating, or member, brokerage firms. It also
may borrow money from the SEC if its own funds are insufficient to meet its obligations.
In addition to federal regulations, security trading is subject to state laws, known generally
as blue sky laws because they are intended to give investors a clearer view of investment
prospects. State laws to outlaw fraud in security sales existed before the Securities Act of
1933. Varying state laws were somewhat unified when many states adopted portions of the
Uniform Securities Act, which was enacted in 1956.


Self-Regulation and Circuit Breakers
Much of the securities industry relies on self-regulation. The SEC delegates to secondary ex-
changes such as the NYSE much of the responsibility for day-to-day oversight of trading.
Similarly, the National Association of Securities Dealers oversees trading of OTC securities.
The Institute of Chartered Financial Analysts™ Code of Ethics and Professional Conduct sets
out principles that govern the behavior of CFAs. The nearby box presents a brief outline of
those principles.
The market collapse of October 19, 1987, prompted several suggestions for regulatory
change. Among these was a call for “circuit breakers” to slow or stop trading during periods
of extreme volatility. Some of the current circuit breakers being used are as follows:

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